Vanna-volga pricing

Uwe Wystup

No 11, CPQF Working Paper Series from Frankfurt School of Finance and Management, Centre for Practical Quantitative Finance (CPQF)

Abstract: The vanna-volga method, also called the traders' rule of thumb is an empirical procedure that can be used to infer an implied-volatility smile from three available quotes for a given maturity. It is based on the construction of locally replicating portfolios whose associated hedging costs are added to corresponding Black-Scholes prices to produce smile-consistent values. Besides being intuitive and easy to implement, this procedure has a clear financial interpretation, which further supports its use in practice.

Date: 2008
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