Skip to main content

Calibrating the Italian Smile with Time-Varying Volatility and Heavy-Tailed Models


In this paper, we consider several time-varying volatility and/or heavy-tailed models to explain the dynamics of return time series and to fit the volatility smile for exchange-traded options where the underlying is the main Italian stock index. Given observed prices for the time period we investigate, we calibrate both continuous-time and discrete-time models. First, we estimate the models from a time-series perspective (i.e. under the historical probability measure) by investigating more than 10 years of daily index price log-returns. Then, we explore the risk-neutral measure by fitting the values of the implied volatility for numerous strikes and maturities during the highly volatile period from April 1, 2007 (prior to the subprime mortgage crisis in the US) to March 30, 2012. We assess the extent to which time-varying volatility and heavy-tailed distributions are needed to explain the behavior of the most important stock index of the Italian market.

This is a preview of subscription content, access via your institution.

Fig. 1
Fig. 2
Fig. 3
Fig. 4


  1. For simplicity in the following we refer to \((X_t)_{t\ge 0}\) as \(X_t\).

  2. The characteristic exponent is defined in “Change of Measure for Lévy process” Appendix.

  3. In both the CTS and NIG cases we select a truncation function h, as defined in the “Change of Measure for Lévy process” Appendix, such that if \(m=0\), then the process has zero mean.

  4. A VG process can be viewed as the limiting case of a CTS with \(\alpha \) going to zero.

  5. The unusual timing \(\lambda t\) is deliberately chosen so that the marginal distribution of \(v_t\) is independent of the choice of \(\theta \) (see Barndorff-Nielsen and Shephard 2001).

  6. This means that if one starts the process with an initial value sampled from the D distribution, at each future time t, \(v_t\) is distributed as D.

  7. One has to assume the law is D self-similar. For the definition of self-similarity, see Sato (1999).

  8. See Schoutens (2003) and Bianchi and Fabozzi (2015) for more details on this process.

  9. A stdCTS law has distribution with zero mean and unit variance (see Scherer et al. 2012). In the following we will refer to it as stdCTS with parameters (\(\lambda _-\), \(\lambda _+\), \(\alpha \)).

  10. We consider the market implied volatility surface and not Bloomberg evaluations (see Cui and Zhang 2011).

  11. We use the Matlab r2011a function fzero.

  12. We use the Matlab r2014b function fmincon for the optimization routine and a function found on the Paul Wilmott web-site (see to compute the implied volatilities from the values of option prices. This function is much faster then the standard Matlab blsimpv function. The procedure was run on an 8 cores AMD FX processor with 16GB of Ram with a Linux based 64-bit operating system.

  13. As in the continuous-time case, we use the Matlab r2014b function fmincon for the optimization routine and a function found on the Paul Wilmott web-site to compute the implied volatilities from the values of option prices.

  14. ARPE is defined as

    $$\begin{aligned} \textit{ARPE} = \frac{1}{\text {NumObs}}\sum _{T_i}\sum _{K_j}\frac{\left| iVol^{market}_{T_i K_j} - iVol^{model}_{T_i K_j}\right| }{iVol^{market}_{T_i K_j}}. \end{aligned}$$
  15. As discussed above, Yu et al. (2011) showed that the Heston-VG model can efficiently be applied to capture the joint dynamics of stock and short-term options closest to the money (i.e., with a strike-to-spot price ratio close to one). Here we consider a larger option dataset in terms of moneyness and maturities on a different underlying.

  16. See Bianchi and Fabozzi (2015) and the references therein for a discussion on this topic.


  • Albrecher, H., Mayer, P., Schoutens, W., & Tistaert, J. (2007). The little Heston trap. London: Wilmott Magazine.

    Google Scholar 

  • Barndorff-Nielsen, O. E., & Shephard, N. (2001). Non-Gaussian Ornstein-Uhlenbeck-based models and some of their uses in financial economics. Journal of the Royal Statistical Society: Series B (Statistical Methodology), 63(2), 167–241.

    Article  Google Scholar 

  • Barone Adesi, G., Engle, R. F., & Mancini, L. (2008). A GARCH option pricing model with filtered historical simulation. Review of Financial Studies, 21(3), 1223–1258.

    Article  Google Scholar 

  • Bhar, R. (2010). Stochastic filtering with applications in finance. Singapore: World Scientific.

    Book  Google Scholar 

  • Bianchi, M. L., & Fabozzi, F. J. (2015). Investigating the performance of non-Gaussian stochastic intensity models in the calibration of credit default swap spread. Computational Economics, 46(2), 243–273.

    Article  Google Scholar 

  • Bianchi, M.L., Rachev, S.T., Fabozzi, F.J. (2016). Tempered stable Ornstein-Uhlenbeck processes: A practical view. Communications in Statistics: Simulation and Computation.

  • Brigo, D., & Mercurio, F. (2006). Interest rate models: Theory and practice: With smile, inflation, and credit. New York: Springer.

    Google Scholar 

  • Carr, P., & Madan, D. (1999). Option valuation using the fast fourier transform. Journal of Computational Finance, 2(4), 61–73.

    Article  Google Scholar 

  • Centanni, S., Ongaro, A. (2011). Computing option values by pricing kernel with a stochastic volatility model. Working paper.

  • Christoffersen, P., Heston, S., & Jacobs, K. (2013). Capturing option anomalies with a variance-dependent pricing kernel. Review of Financial Studies, 26(8), 1963–2006.

    Article  Google Scholar 

  • Christoffersen, P., Jacobs, K., & Mimouni, K. (2010). Volatility dynamics for the S&P500: Evidence from realized volatility, daily returns, and option prices. Review of Financial Studies, 23(8), 3141–3189.

    Article  Google Scholar 

  • Ciccone, E., Giordano, L., Grasso, R. (2011). Why are derivative warrants more expensive than options? The Italian case. Discussion papers, Consob, n. 2.

  • Cont, R., & Tankov, P. (2004). Financial modelling with jump processes. London: Chapman & Hall.

    Google Scholar 

  • Cui, C., Zhang, K. (2011). Equity implied volatility surface. Quantitative Research and Development, Bloomberg, Version 3.5.

  • Douc, R., Cappé, O. (2005). Comparison of resampling schemes for particle filtering. In Proceedings of the IEEE 4th international symposium on image and signal processing and analysis (pp. 64–69).

  • Duan, J. C. (1995). The GARCH option pricing model. Mathematical Finance, 5(1), 13–32.

    Article  Google Scholar 

  • Duan, J. C., & Simonato, J. G. (1998). Empirical martingale simulation for asset prices. Management Science, 44(9), 1218–1233.

    Article  Google Scholar 

  • Engle, R. F., & Ng, V. K. (1993). Measuring and testing the impact of news on volatility. The Journal of Finance, 48(5), 1749–1778.

    Article  Google Scholar 

  • Fang, F., Jönsson, H., Oosterlee, K., & Schoutens, W. (2010). Fast valuation and calibration of credit default swaps under Lévy dynamics. Journal of Computational Finance, 14(2), 1–30.

    Article  Google Scholar 

  • Geman, H., Madan, D. B., & Yor, M. (2001). Time changes for Lévy processes. Mathematical Finance, 11(1), 79–96.

    Article  Google Scholar 

  • Geman, H., Madan, D. B., & Yor, M. (2002). Stochastic volatility, jumps and hidden time changes. Finance and Stochastics, 6(1), 63–90.

    Article  Google Scholar 

  • Guillaume, F. (2012). Sato two-factor models for multivariate option pricing. Journal of Computational Finance, 15(4), 159–192.

    Article  Google Scholar 

  • Guillaume, F., & Schoutens, W. (2012). Calibration risk: Illustrating the impact of calibration risk under the Heston model. Review of Derivatives Research, 15(1), 57–79.

    Article  Google Scholar 

  • Heston, S. L. (1993). A closed-form solution for options with stochastic volatility with applications to bond and currency options. Review of Financial Studies, 6(2), 327–343.

    Article  Google Scholar 

  • Heston, S. L., & Nandi, S. (2000). A closed-form GARCH option valuation model. Review of Financial Studies, 13(3), 585–625.

    Article  Google Scholar 

  • Hull, J. (2002). Options, futures and other derivatives (5th ed.). Upper Saddle River: Prentice Hall.

    Google Scholar 

  • Hurst, S. R., Platen, E., & Rachev, S. T. (1997). Subordinated market index models: A comparison. Asia-Pacific Financial Markets, 4(2), 97–124.

    Google Scholar 

  • Hurst, S. R., Platen, E., & Rachev, S. T. (1999). Option pricing for a logstable asset price model. Mathematical and Computer Modelling, 29(10), 105–119.

    Article  Google Scholar 

  • Kim, Y. S., & Lee, J. H. (2007). The relative entropy in CGMY processes and its applications to finance. Mathematical Methods of Operations Research, 66(2), 327–338.

    Article  Google Scholar 

  • Kim, Y. S., Rachev, S. T., Bianchi, M. L., & Fabozzi, F. J. (2010). Tempered stable and tempered infinitely divisible GARCH models. Journal of Banking & Finance, 34(9), 2096–2109.

    Article  Google Scholar 

  • Lando, D. (2004). Credit risk modeling: Theory and applications. Princeton: Princeton University Press.

    Google Scholar 

  • Lehar, A., Scheicher, M., & Schittenkopf, C. (2002). Garch vs. stochastic volatility: Option pricing and risk management. Journal of Banking & Finance, 26(2), 323–345.

    Article  Google Scholar 

  • Li, J. (2011). Sequential bayesian analysis of time-changed infinite activity derivatives pricing models. Journal of Business and Economic Statistics, 29(4), 468–480.

    Article  Google Scholar 

  • Lopes, H. F., & Tsay, R. S. (2010). Particle filters and Bayesian inference in financial econometrics. Journal of Forecasting, 30, 168–209.

    Article  Google Scholar 

  • Malik, S., Pitt, M.K. (2011). Modelling stochastic volatility with leverage and jumps: A simulated maximum likelihood approach via particle filtering. Banque de France, Working paper No. 318.

  • Mandelbrot, B. (1963). The variation of certain speculative prices. Journal of Business, 36(4), 394–419.

    Article  Google Scholar 

  • Muzzioli, S. (2011). Corridor implied volatility and the variance risk premium in the Italian market. Working paper.

  • Nicolato, E., & Venardos, E. (2003). Option pricing in stochastic volatility models of the Ornstein-Uhlenbeck type. Mathematical Finance, 13(4), 445–466.

    Article  Google Scholar 

  • Rachev, S., & Mittnik, S. (2000). Stable Paretian models in finance. New York: Wiley.

    Google Scholar 

  • Rachev, S. T., Kim, Y. S., Bianchi, M. L., & Fabozzi, F. J. (2011). Financial models with Lévy processes and volatility clustering. New York: Wiley.

    Book  Google Scholar 

  • Sato, K. I. (1999). Lévy processes and infinitely divisible distributions. Cambridge: Cambridge University Press.

    Google Scholar 

  • Scherer, M., Rachev, S. T., Kim, Y. S., & Fabozzi, F. J. (2012). Approximation of skewed and leptokurtic return distributions. Applied Financial Economics, 22(16), 1305–1316.

    Article  Google Scholar 

  • Schoutens, W. (2003). Lévy processes in finance: Pricing financial derivatives. New York: Wiley.

    Book  Google Scholar 

  • Tassinari, G. L., & Bianchi, M. L. (2014). Calibrating the smile with multivariate time-changed Brownian motion and the Esscher transform. International Journal of Theoretical and Applied Finance, 17(4).

  • Wu, L. (2008). Modeling financial security returns using Lévy processes. In J. R. Birge & V. Linetsky (Eds.), Handbooks in operations research and management science, volume 15, financial engineering (pp. 117–162). Amsterdam: Elsevier.

    Google Scholar 

  • Yu, C. L., Li, H., & Wells, M. T. (2011). MCMC estimation of Lévy jumps models using stock and option prices. Mathematical Finance, 21(3), 383–422.

    Article  Google Scholar 

Download references

Author information

Authors and Affiliations


Corresponding author

Correspondence to Frank J. Fabozzi.



Change of Measure for Lévy process

Before explaining how to find a proper change of measure between the market measure \(\mathrm {P}\) and the risk-neutral measure \(\mathrm {Q}\), we review, some useful definitions.

Theorem 1

(Lévy-Khintchine formula) A probability law \(\mu \) of a real-valued random variable X on \(\mathbb {R}\) is infinitely divisible with characteristic exponent \(\psi \),

$$\begin{aligned} \int _{\mathbb {R}} e^{i\theta x}\mu (dx) = e^{\psi (\theta )}\quad \text {for}\;\theta \in \mathbb {R}\end{aligned}$$

if and only if there exists a triple \((a_h,\sigma ,\nu )\) where \(a_h\in \mathbb {R}\), \(\sigma \ge 0\), \(\nu \) is a measure on \(\mathbb {R}\backslash \{0\}\) satisfying

$$\begin{aligned} \int _{\mathbb {R}\backslash \{0\}} (1\wedge x^2)\nu (dx)<\infty \end{aligned}$$

and h is a given truncation function such that

$$\begin{aligned} \psi (\theta ) = ia\theta - \frac{1}{2}\sigma ^2\theta ^2 + \int _{\mathbb {R}\backslash \{0\}} ( e^{i\theta x}- 1 - i\theta h(x))\nu (dx) \end{aligned}$$

for every \(\theta \in \mathbb {R}\).

We say that our infinitely divisible distribution \(\mu \) has Lévy triplet \((a_h, \sigma , \nu )\). The measure \(\nu \) is called the Lévy measure of \(\mu \), \(\sigma \) represents the Gaussian component, and a is a constant depending on the truncation function h. If the Lévy measure is of the form \(\nu (dx) = u(x)dx\), we call u(x) the Lévy density. If \(\mu \) is an infinitely divisible distribution, there exists a Lévy process \((X_t)_{t\ge 0}\) such that the distribution of \(X_1\) is \(\mu \).

Now, we want to find conditions under which the Lévy process \(X_t\) under the measure \(\mathrm {P}\) is still a Lévy process under a new measure \(\mathrm {Q}\). In order to find an equivalent measure, we will consider the general result of density transformation between Lévy processes proven in Sato (1999). Even if we restrict our attention to structure-preserving measures, the class of probabilities equivalent to a given one is surprisingly large. Nonetheless, as stated in the following theorem (statement 3.), we cannot freely change the drift \(a_h\) if a diffusion component is not present, that is if \(\sigma = 0\).

Theorem 2

Let \((X_t, \mathrm {P})\) and \((X_t^*, \mathrm {Q})\) be Lévy processes on \(\mathbb {R}\) with generating triplets \((a_h,\sigma ,\nu )\) and \((a_h^*,\sigma ^*,\nu ^*)\), respectively. Then, \(\mathrm {P}\) and \(\mathrm {Q}\) are equivalent for each t if and only if

  1. 1.

    \(\sigma = \sigma ^*\);

  2. 2.

    The following integral is finite

    $$\begin{aligned} \int _{\mathbb {R}}(e^{\varphi (x)/2}-1)^2\nu (dx)<\infty , \end{aligned}$$

    with the function \(\varphi (x)\) defined by \(\frac{d\tilde{\nu }}{d\nu } = e^{\varphi (x)}\);

  3. 3.

    The constant b is such that

    $$\begin{aligned} a_h^* - a_h - \int _{\mathbb {R}}h(x)(\nu ^* -\nu )(dx) = b \sigma ^2 \end{aligned}$$

    if \(\sigma > 0\) and zero if \(\sigma =0\).


See Theorem 33.1 in Sato (1999) and Cont and Tankov (2004). \(\square \)

Particle Filter

In continuous-time stochastic volatility models, the unobserved volatility can be inferred by the observed stock returns. Since in most of the cases one deals with daily returns, the model has to be discretized. In all the cases we are interested in, the model can be written as

$$\begin{aligned} \begin{aligned} v_t&= f(v_{t-1},\varTheta ,\xi _{t-1})\\ y_t&= h(v_{t},\varTheta ) + \sqrt{v_t}\varepsilon _{t}\\ \end{aligned} \end{aligned}$$

where \(v_t = \sigma ^2_t\), t is the day counter, \(v_t\) is the square of the stochastic volatility modeled as a Markov process with initial distribution \(p(v_0)\), and transition law \(p(v_t|v_{t-1})\). Both p and the transition function f depends on the dynamics described by model chosen. The variable \(y_t\) represents the set of given observations (in our case the observed index log-returns). It is assumed to be conditionally independent given the state \(v_t\) and with distribution \(p(y_t|v_t)\). Then, \(\xi _{t-1}\) depends on the volatility dynamics and the noise \(\varepsilon _t\) is normally distributed noise with mean zero and unit variance, at least in the stochastic volatility models we are interested in studying. The function h is the so-called measurement function, that in our case is given by the stock price returns model and \(\varTheta \) is a set of static parameters.

Particle filter is a sequential Monte Carlo method for recursively approximating the posterior density \(p(v_t|y_{1:t})\) by assuming a known measurement density \(h(y_t|v_t)\) and the ability to simulate from the Markov transition density \(f(v_{t+1}|v_t)\). The algorithm estimates the posterior density by considering a set of random samples with associated weights \(\{v_t^i, w_t^i\}_{i=1}^N\) where N is the number of samples at each given point in time t. The algorithm, also known as the bootstrap filter, includes three main steps: (a) sampling, (b) weights computation, and (c) resampling. In our empirical test we proceed as follows:

  1. 1.

    we sample \(v_t^i\) from the distribution \(p(v_t|v_{t-1})\) with i ranges from 1 to N, where N is equal to 5000;

  2. 2.

    we compute the weight as follows

    $$\begin{aligned} w_t^i = -\frac{1}{\sqrt{2\pi v_t^i}} \exp \left( -\frac{(y_t^{observed} - h(v_t^i,\varTheta ))^2}{2v_t^i}\right) , \end{aligned}$$

    evaluate the likelihood estimate

    $$\begin{aligned} \widehat{L_t} = \frac{1}{N}\sum _{i=1}^N w_t^i \end{aligned}$$

    and then normalize the weights in order to have \(\sum _{i=1}^N w_t^i = 1\).

  3. 3.

    we resample by taking into consideration the smooth resampling algorithm (see Douc and Cappé 2005 and Malik and Pitt (2011)) and we obtain a new set of samples \(\tilde{v}_t^i\) approximately distributed according to \(p(v_t|y_{1:t})\) and evaluate the state

    $$\begin{aligned} \widehat{v}_t = \frac{1}{N}\sum _{i=1}^N v_t^i; \end{aligned}$$

To estimate the parameters \(\varTheta \), we build the joint log-likelihood over the entire observation period, that is

$$\begin{aligned} LL(\varTheta , y_{1:T}) = \sum _{t=1}^T \log \left( \widehat{L_t}\right) , \end{aligned}$$

and, finally, we insert this function into an optimization procedure. We use the Matlab r2011a function fmincon as the optimization routine. The classical Heston and the SV-GammaOU models have a better convergence property compared to other competitor stochastic volatility continuous-time models. This is mainly due to the number of parameters to be estimated.

Rights and permissions

Reprints and Permissions

About this article

Verify currency and authenticity via CrossMark

Cite this article

Bianchi, M.L., Rachev, S.T. & Fabozzi, F.J. Calibrating the Italian Smile with Time-Varying Volatility and Heavy-Tailed Models. Comput Econ 51, 339–378 (2018).

Download citation

  • Accepted:

  • Published:

  • Issue Date:

  • DOI:


  • Volatility smile
  • Stochastic volatility models
  • GARCH model
  • Non-Gaussian Ornstein-Uhlenbeck processes
  • Lévy processes
  • Tempered stable processes and distributions

Mathematics Subject Classification

  • 60E07
  • 60G51
  • 91G20
  • 91G60