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Pricing Forward Skew Dependent Derivatives. Multifactor Versus Single‐Factor Stochastic Volatility Models
Author(s) -
Marabel Romo Jacinto
Publication year - 2014
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/fut.21611
Subject(s) - skew , stochastic volatility , volatility smile , econometrics , valuation (finance) , implied volatility , economics , forward volatility , volatility risk , volatility (finance) , sabr volatility model , valuation of options , volatility swap , computer science , finance , telecommunications
Empirical evidence shows that, in equity options markets, the slope of the skew is largely independent of the volatility level. Single‐factor stochastic volatility models are not flexible enough to account for the stochastic behavior of the skew. On the other hand, multifactor stochastic volatility models are able to account for the existence of stochastic skew. This study studies the effects of introducing stochastic skew in the valuation of forward skew dependent exotic options. In particular, I consider cliquet, as well as reverse cliquet structures. The study also derives a semi‐closed‐form solution for the price of forward‐start options under the multifactor stochastic specification. The empirical results indicate that the consideration of additional volatility factors in the context of stochastic volatility models allows us to generate more flexible smile patterns. This additional flexibility has a relevant impact on the valuation of forward skew dependent derivatives. In this sense, this study shows that similar calibrations of single factor and multifactor stochastic volatility models to the current market prices of plain vanilla options can lead to important discrepancies in the pricing of exotic forward skew dependent derivatives such as regular cliquet structures and reverse cliquet options. © 2013 Wiley Periodicals, Inc. Jrl Fut Mark 34:124–144, 2014

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