SPX, VIX and scale-invariant LSV∗

Alexander Lipton & Adil Reghai

arXiv:2302.08819v1 [q-fin.MF] 17 Feb 2023

First version November 2022 / This version February 2023

Abstract
Local Stochastic Volatility (LSV) models have been used for pricing
and hedging derivatives positions for over twenty years. An enormous
body of literature covers analytical and numerical techniques for calibrat-
ing the model to market data. However, the literature misses a potent
approach commonly used in physics and works with absolute (dimen-
sional) variables rather than with relative (non-dimensional) ones. While
model parameters defined in absolute terms are counter-intuitive for trad-
ing desks and tend to be heavily time-dependent, relative parameters are
intuitive and stable, making it easy to steer the model adequately and
consistently with its Profit and Loss (PnL) explanation power. We pro-
pose a specification that first explores historical data and uses physically
well-defined relative quantities to design the model. We then develop an
efficient hybrid method to price derivatives under this specification. We
also show how our method can be used for robust scenario generation
purposes - an important risk management task vital for buy-side firms.1

1 Introduction
Modern financial engineering started with the Black & Scholes model developed;
see Black and Scholes (1973). This model has created a consensus for pricing
the simplest derivative options, vanilla ones. Black & Scholes implied volatility
is a shared concept that any market practitioner can infer from market prices.
It is the solid pillar behind the volatility smile description.
However, the Black & Scholes model has severe limitations when pricing
advanced derivatives, especially those with changing second-order exposures;
see, e.g., Reghai (2015) when it comes to the gamma exposures. Following the
first principles of derivative valuation, the explanation of PnL or replication
is the primary judge of the quality of a model; see. e.g., Lipton (2002). Thus,
practitioners needed a model that could consistently price those derivatives with
the volatility smile. Bick and Reisman (1993), Dupire (1994), and Derman et
∗ Local
Stochastic Volatility
1 The
authors would like to thank Prof. Marcos Lopez de Prado and Dr. Vincent Davy
Zoonekynd for valuable comments.

1
al. (1996) developed such a model through the introduction of local volatility.
This model solved the pricing issue in the presence of the smile, particularly the
changing gamma exposure over time and spot value. However, despite its wide
usage by the industry, the local volatility model only included the static cost
of hedging the smile. In theory, the model accounts only for the introduction
of the different vanillas at the inception of the trade. In practice, traders, risk
managers, and quants all realized quickly that during the life of the trade,
an additional systematic cost arises when the trader readjusts her position.
Nevertheless, the readjustment costs are not adequately considered under the
local volatility model. Therefore, the industry needed models consistent with
the static and dynamic cost of hedging.
The solution for this problem was introduced long ago and labeled the Lo-
cal Stochastic Volatility (LSV) model of Jex et al. (1999) and Lipton (2002).
In theory, the model was perfectly adequate. However, in practice, both the
local volatility and the LSV had specifications pitfalls that generated recurrent
problems when applied on the industrial scale. In particular, they were based
on absolute levels of the spot. Some practitioners partially tackled the prob-
lem by normalizing with the forward values to circumvent this issue. However,
little information was documented, resulting in arbitrary choices and signifi-
cant differences from one bank to the other. Accordingly, although prices were
marginally impacted, the resulting hedges were not necessarily correct.
In Hobson and Rogers (1998), an exciting class of path-dependent local
volatility models was proposed. A specific version was examined with the volatil-
ity depending on the difference between the current price and an exponential
average of past prices. This property is appealing to traders as it reflects the
perception that large movements of the asset price in the past tend to fore-
cast higher future volatility. This model exhibits a wide variety of smiles and
skews. Lipton emphasized that all meaningful models have to be scale-invariant
(dimensionless); see Lipton (1999, 2001, 2017). Lipton recommended building
physical models depending on functions of dimensionless arguments of the time
and spot parameters t and St and introduced the general form of such a model
based on a kernel. In Guyon (2014); Guyon and Lekeufack (2022), the same
observation was made regarding local volatility setup, showing how to capture
prominent historical volatility patterns using path-dependent local volatility.
Hagan et al. (2002) present an analytically tractable formula that is scale-
invariant and has both local and stochastic volatility. However, the local volatil-
ity part, being parametric and rigid, does not permit fitting the whole volatility
surface.
We need to keep several typical trading conundrums in mind to design a
proper approach to the problem at hand.

• Traders know very well that path dependency strongly impacts the volatil-
ity dynamic. It is an essential factor in their PnL explanation for the cost
of hedging. Consider the Spx index. The implied volatility surface when
the spot level is at 4000 depends on its previous levels. On the one hand,
if the spot went down before, then the implied volatility surface would be

2
 higher, reflecting an elevated level of risk. On the other hand, if the spot
comes from lower levels, then the implied volatility is certainly lower as
the market is pricing a momentum movement.
• Traders think in relative terms, and to be consistent with the industry,
the volatility modeling must rely on a dimensionless approach.

• Traders operate on multiple time scales. They infer the cost of future
volatility hedging through the recent evaluation of the market movement.
They know that different players (institutional investors, asset managers,
day traders, and statistical arbitrageurs) all impact market volatility.

• This set of models is vital for correctly determining the volatility dynamic,
which is essential for hedging vanilla options and pricing path dependant
options such as barrier or autocall options.
Our paper aims to provide an in-depth analysis of the most traded assets,
SPX and VIX. Section 2 presents the SDE governing the LSV model. Section
3 explores data and presents the critical link between SPX and VIX. It shows
that the scale-invariant specification gives excellent results both in-sample and
out-of-sample. Section 4 presents different techniques for pricing derivatives,
some of which are highly efficient and useful for production purposes. In partic-
ular, the impact on pricing classical path-dependent options is reasonably high.
Section 5 briefly deals with scenario generation and involves creating hypothet-
ical scenarios to simulate different realistic market conditions. Finally, Section
6 concludes.
The paper provides a comprehensive understanding of the financial market
and is valuable for financial analysts, traders, and risk managers.

2 The process
We are interested by the process of the form:
dSt p
= (r − q)dt + σloc eYt (ρdWt + 1 − ρ2 dBt ), (1)
St
dYt = −κYt dt + νdWt , (2)

where r, q are the risk neutral rate and dividend yield,

!
t St
σloc = f ,R , (3)
t̄ t φ(t, u)Su du
−∞

where t̄ is a representative timescale, and φ is a suitable averaging kernel, for

example

φ(t, u) = κe−κ(t−u) . (4)

3
 St
The scale invariant index It = Rt
φ(t,u)Su du
satisfies the following stochastic
−∞
differential equation (SDE):

dIt p
= ((r − q) − φ(t, t)It )dt + σloc eYt (ρdWt + 1 − ρ2 dBt ). (5)
It
The natural scale for this index is the unity, and a deviation from it can be
seen as a shock or a surprise and therefore generates a different value for the
risk. Risk, in our case, is a forward-looking measure that the VIX represents.

Figure 1: VIX and SPX as functions of time. Own graphics. Source : Factset.

3 Data exploration
In this section, we will explore historical data. We shall observe the historical
paths for the SPX and VIX and qualitatively determine the type of links between
these two quantities. In particular, we shall see that describing the VIX as a
function of the absolute level of the SPX is not straightforward. Also, using a
moving average kernel, we observe that this creates more data structure. Finally,
we shall seek an optimal kernel designed to maximize the fit of the VIX as a
function of the dimensionless quantity of the path.

3.1 VIX as a function of the spot

We consider a long period of time starting from the beginning of the 1990 till
the end of 2022.
In Figures 1, 2, we can observe that the VIX as a function of the absolute spot
level shows little structure as expected because traders recognize many skewed
regimes associated with different periods. Each period corresponds to some
characteristic level of spot. In Figure 3, we observe different local behaviour of
the volatility relatively to the absolute level of the SPX. In particular, one can

4
 Figure 2: Global Fit. Own graphics.

Figure 3: Local Fit per period of 5 years. Own graphics.

5
 Period Intercept Slope R2 Score
[1990-1995] 30.4 -0.0352 42.78
[1995-2000] 9.4 0.0115 38.34
[2000-2005] 36.06 -0.013 10.34
[2005-2010] 71.14 -0.0407 44.02
[2010-2015] 33.85 -0.0099 32.67
[2015-2020] 8.44 0.0035 3.73
[2020- ] 62.06 -0.0097 37.27

Table 1: Score per period of 5 years

see that for a level of around 3500 there is hysteresis, i.e. the volatility is either
increasing or decreasing depending on the period under scrutiny. The levels of
R2 scores are shown in Table 1.
In Figure 4, we try different classical moving averages that are classical in
the trading industry. Each moving average is a particular, in equation (6), a
kernel with equal weights for each spot within the averaging window is shown.
More precisely, for a lag of n days, the kernel is given by:
1
φ(t, u) =1t−u≤n . (6)
n
We examine different lags based on trading rationals that are exposed below.

• 50 days: The 50-day moving average is a reliable technical indicator used

by several investors to analyze price trends. It is a security’s average
closing price over the previous 50 days. The 50-day moving average is
popular because it is a realistic and effective trend indicator in the stock
market.
• 100 days: A moving average of 100 days helps investors see how the stock
has performed over 20 weeks and find the price trend if it is upward or
downward, which gives them a sense of the market sentiment as well.
• 200 days: The 200-day moving average is perceived as the dividing line
between a technically healthy stock and one that is not. Furthermore, the
percentage of stocks above their 200-day moving average helps determine
the market’s overall health.
• 250 days: The 250 period moving average is popular on the daily chart
since it describes one year of the price action (one year has roughly 250
trading days).

Note that in Table 2 that the constant coefficient is not loaded, which is
natural since we are regressing two non-dimensional quantities. Also, note that
the ratio between the slope coefficient is negative for all time scales, as expected.
Finally, the ratio of the slope coefficient and the curvature one are all of the
same levels, i.e., the level of the average VIX value. For the last experiment,

6
 Figure 4: Fit using natural trading scales. Own graphics.

see equations (7, 8, 10) we perform an optimization described as follows. We

choose a length n for the kernel. We assume that it is a stationary kernel with
positive weights.
T
1 X
min (V IXt − (a + bI + cI 2 ))2 (7)
φ1 ,...,φn ,a,b,c T − n + 1
t=n

where
St
I= , (8)
φ1 St−n + ... + φn St−1
subject to:

φ1 + ... + φn = 1 (9)
φi ≥ 0 ∀i (10)

7
 Method a b c score
50 days 0 -1966.13 947.69 44.1
100 days 0 -1302. 618. 55.29
200 days 0 -676 311. 56.24
250 days 0 -548. 250. 54.83

Table 2: V ix(t) = a + bx + cx2

We use a classic reparametrization of the weights, as in equation (11), to

perform a non-constrained optimization. More precisely, we search for ψi such
that:

eψi
φi = P ψj , (11)
je

Now ψi , ∀i are free from constraints.

3.2 In-sample results

Below we perform an in-sample study where we identify the functional form for
the period [1990-2010].

Method a b c R2 score
Optimised 50 days 72.12 3.96 -56.32 82.77
Optimised 100 days 92.25 2.49 -74.2 86.73
Optimised 200 days 66.18 4.25 -49.17 88.07
Optimised 250 days 75.02 3.47 -57.13 88.55

Table 3: V ix(t) = a + bx + cx2

Table 3 demonstrates that the quality of the R2 score has improved signif-
icantly to up to 88%. We shall measure the fit quality for the out-of-sample
period in the next section.

3.3 Out-of-sample results

This section measures the score of the previously calibrated models for the out-
of-sample period [2010-2022]. The corresponding results are shown in Table
4.

3.4 Optimised weights

We optimize weights for four representative periods - 50, 100, 200, and 250 days.
The corresponding results are presented in Figure 5. Optimal weights do not
have a clear structure for shorter periods, while for longer periods, they are
well-formed.

8
 Method R2 score
Optimised 50 days 84.09
Optimised 100 days 87.7
Optimised 200 days 88.4
Optimised 250 days 88.53

Table 4: R2 score using optimised weights.

Figure 5: Optimised weights. Own graphics.

Figure 6 shows that the optimally identified kernel reduces the cloud width
compared to the moving average previously calculated. Remarkably, the ob-
tained kernel resembles a power law in the form of a fast-decreasing shape as
described Bergomi (2016); see Figure 7.
The corresponding indices It200 and It250 are shown in Figure 8.

9
 Figure 6: Optimised fit. Own graphics.

Figure 7: Functional form of the weights. 200 days average: score-weight 0.9948,
parameters: [0 -0.38 -0.08]; 250 days average: score-weight 0.9839, parameters:
[0 0.82 -0.23]. Own graphics.

3.5 Innovations
The relationship between VIX and SPX is complex and dynamic, and no one-
size-fits-all approach works in all market conditions. However, the dimensional
approach provides a good proxy for such a relationship. Besides, it gives a
causal relationship between levels of VIX and surprises or shocks expressed as
the distance between the current SPX spot and its weighted average using the
previously identified kernel. In Figure 9, we plot the following ratio:

10
 Figure 8: Out Sample : Indices It200 and It250 . Own graphics.

V IXt
yt = ln( St
). (12)
f ( φ1 St−n +...+φ n St−1
)
which represents stochastic innovations unexplained by the local volatility con-
tributions.

Figure 9: Innovations. Own graphics.

We estimate the volatility process using an autoregressive AR(1) the cor-

responding yt . The fit on yt is excellent; see Figure 10. It has a R2 score of
96.75%.
Thus, the discrete dynamics of the innovations can be written as follows:

yt+1 = 0.9822yt + 0.0026t+1 , (13)

where t ∼ N (0, 1).

11
 Figure 10: The autoregressive fit of the innovations. Own graphics.

4 Derivatives pricing
4.1 Background
We combine the one-dimensional Monte Carlo simulation and the quantization
technique method to design an efficient technique for pricing derivative options
on assets in the LSV model. Our approach is similar to the approach proposed
in Lipton and Sepp (2022) with few modifications. First, we condition the dy-
namics on the realization of the Y process. The idea is the same; however, we
rely on the functional quantization technique because the conditional price of
a derivative is smooth enough with respect to the volatility path so that there
is not obligatory to use Monte Carlo on Y . In practice, only three quantizers
are enough to capture the conditional convexity of the products with respect to
this variable. Second, as described in Lipton and Sepp (2022), we price deriva-
tives conditionally to the Y process. In practice can be done in several ways,
depending on the problem’s dimensionality. For mono-asset barrier options, one
can use PDEs. For multi-dimensional problems, one can use Monte Carlo. It
is crucial to note that this pricing methodology is extremely fast and smooth
both for the mono and multi assets pricing. Therefore, it is a good candidate
for pricing and risk management industrialization.
We start by illustrating the method for vanilla options and consider a call
option with maturity T and strike K.
We first introduce a functional quantization partition Ci (y) with Q quantizer
as described in Pages and Printems (2005). One can note that the Orstein-
Uhlenbeck process is treated analytically as an example in Pages and Printems
(2005).
We define a quantization Ŷ y of Y that can be used in the following quadra-
ture formula. For a given functional F : L2 [0, T ] 7→ R, and for every y =
(y1 , ..., yQ ) in L2 [0, T ]Q we get:

12
 Q
X
E(F (Ŷ y )) = PY (Ci (y))F (y). (14)
i=1

So if one has numerical access to both the Q-quantizer y and its “companion”
distribution PY (Ci (y)), the computation is straightforward.

E(ST − K)+ = E(E((ST − K)+ |{Yt , t ∈ [0, T ]}) (15)

Q
X
= PY (Ci (y))E((ST − K)+ |y), (16)
i=1

The process S conditioned on the quantization yt , that we note S y , is given

by:

dSty
= µyt σloc dt + νty σloc dBt , (17)
Sty
ρ 0
µyt = (yt + κyt )eyt , (18)
ν
νty
p
= 1 − ρ2 eyt . (19)

Monte Carlo Method can be used to simulate this model. However, the
process S y is no longer a martingale. Instead, it presents a term structure drift
and path-dependent volatility.

4.2 Vanilla option pricing

In this section, we work on the conditional process (17). We can make the
pricing using three different approaches:
• Monte Carlo,
• Partial differential equation,
• and Most likely path approach.
In the Monte Carlo approach, we discretize the time t0 = 0 < t1 < ... <
tn = T and generate random numbers i ∈ N (0, 1) i.i.d (independently and
identically distributed):

S0y = S0 , (20)
y
Si+1 = (1 + (r − q)(ti+1 − ti ))Siy (21)
Siy (µyi σloc (i)(ti+1 − ti ) νiy σloc (i)i
p
+ + ti+1 − ti ), (22)
Siy
σloc (i) = f( i
). (23)
e−κti j=0 eκtj Sjy
P

13
To avoid cumbersome computations, we introduce an additional variable m
representing the running mean:
i
X
mi = eκtj S yj , (24)
j=0

m0 = eκt0 S0 , (25)
mi+1 = mi + eκti+1 Si+1 . (26)

Regarding the partial differential equation (PDE), we introduce a new vari-

able for the weighted average mt :

dmt = ekt St dt, (27)

The value function u(t, s, m) for the vanilla option satisfies the following PDE:
1 s
∂t u + µyt s∂s u + ekt s∂m u + ( )2 ∂ss u = 0, (28)
2 m
u(T, s, m) = (s − K)+ . (29)
The most likely path, cf Reghai (2012), is also an efficient technique to
compute the prices and is well adapted to quantizing the volatility. Figure 11
demonstrates the corresponding results

Figure 11: Implied volatilities calculated by several complementary methods.

Own graphics.

14
4.3 Path-dependent option pricing
We now have several models calibrated on the same smile, and we shall price
different derivative products that depend on the dynamic of the smile; see Mon-
ciaud and Reghai (2021) for further details. Indeed, an emblematic product
widely used by investors is the up-and-out call. The fact that its gamma ex-
posure changes sign requires the smile to be considered in pricing and hedging
Reghai (2015). In addition, the fact that the product can terminate earlier than
its maturity if we touch the deactivating barrier means we must unwind our
vanilla hedging. The cost of such an operation is also dependent on the smile
in the future. Thus the hedging of this product requires taking into account
the dynamics of the smile. We compare the different hedging costs using the
approach described in Monciaud and Reghai (2021) and the newly calibrated
model; see Table 5.

Model Price
Black Scholes 1.93 ± 2.33 × 0.04
Local Volatility 2.91 ± 2.33 × 0.05
LSV as in Monciaud and Reghai (2021) 2.77 ± 2.33 × 0.05
LSV PD 3.12 ± 2.33 × 0.05

Table 5: Price Call Up & Out K=100,B=120.

Table 6 shows hedging costs for variance and volatility swaps.

Model Variance Swap Volatility Swap

Black Scholes 17.49 ± 2.33 × 0.02 17.47 ± 2.33 × 0.01
Local Volatility 18.97 ± 2.33 × 0.04 18.47 ± 2.33 × 0.04
LSV as in Monciaud and Reghai (2021) 18.97 ± 2.33 × 0.02 18.17 ± 2.33 × 0.005
LSV PD 18.97 ± 2.33 × 0.03 18.39 ± 2.33 × 0.05

Table 6: Volatility derivatives prices.

4.4 Final set of equations

Using the parametrization in equation (13) above, as well as a zero correlation
between the spot and the volatility, we get the following set of equations:

dSt
= (r − q)dt + σloc eYt dBt , (30)
St
dYt = −κYt dt + νdWt , (31)
dIt
= ((r − q) − φ(t, t)It )dt + σloc eYt dBt . (32)
It

15
 !
St
σloc = f Rt . (33)
−∞
φ(t, u)Su du

where r, q are the risk neutral rate and dividend yield and φ(t, u) is the power
law weight function given in Figure 7.

5 Scenario generation
Generating consistent trajectories for VIX and SPX is essential for both the buy
and sell sides. For the buy side, it is crucial to generate realistic paths to test
strategies. On the sell side, it is the question of consistency and having a model
matching both SPX and Vix smile.

6 Conclusion
In conclusion, dimensionless data modeling has proven valuable in understand-
ing the complex relationship between VIX and SPX. By removing the units in
the SPX and putting some knowledge about how markets function, we could
identify the proper kernel for modeling the link between SPX and VIX.
After studying the residuals, we could identify that the log ratio is well
represented with a fast mean reverting process.
Combining these two techniques, we end up with a parsimonious generating
model that captures with fidelity some of the main features in financial markets.
Overall, the use of dimensionless data modeling in the analysis of VIX and
SPX highlights the importance of data normalization and the benefits of using
this technique to uncover patterns and relationships in complex data sets.

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