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Small-Time Asymptotics for an Uncorrelated Local-Stochastic Volatility Model

  • Martin Forde
  • Antoine Jacquier

We add some rigour to the work of Henry-Labordère (2009; Analysis, Geometry, and Modeling in Finance: Advanced Methods in Option Pricing (London and New York: Chapman & Hall)), Lewis (2007; Geometries and Smile Asymptotics for a Class of Stochastic Volatility Models. Available at http://www.optioncity.net (accessed 28 May 2011)) and Paulot (2009; Asymptotic implied volatility at the second order with application to the SABR model, Working Paper, Available at papers.ssrn.com/sol3/papers.cfm?abstract_id=1413649 (accessed 11 June 2011)) on the small-time behaviour of a local-stochastic volatility model with zero correlation at leading order. We do this using the Freidlin—Wentzell (FW) theory of large deviations for stochastic differential equations (SDEs), and then converting to a differential geometry problem of computing the shortest geodesic from a point to a vertical line on a Riemmanian manifold, whose metric is induced by the inverse of the diffusion coefficient. The solution to this variable endpoint problem is obtained using a transversality condition, where the geodesic is perpendicular to the vertical line under the aforementioned metric. We then establish the corresponding small-time asymptotic behaviour for call options using Hölder's inequality, and the implied volatility (using a general result in Roper and Rutkowski (forthcoming, A note on the behavior of the Black--Scholes implied volatility close to expiry, International Journal of Thoretical and Applied Finance). We also derive a series expansion for the implied volatility in the small-maturity limit, in powers of the log-moneyness, and we show how to calibrate such a model to the observed implied volatility smile in the small-maturity limit.

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File URL: http://hdl.handle.net/10.1080/1350486X.2011.591159
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Article provided by Taylor & Francis Journals in its journal Applied Mathematical Finance.

Volume (Year): 18 (2011)
Issue (Month): 6 (April)
Pages: 517-535

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Handle: RePEc:taf:apmtfi:v:18:y:2011:i:6:p:517-535
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