Calibrating local volatility models with stochastic drift and diffusion
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Abstract: We propose Monte Carlo calibration algorithms for three models: local volatility with stochastic interest rates, stochastic local volatility with deterministic interest rates, and finally stochastic local volatility with stochastic interest rates. For each model, we include detailed derivations of the corresponding SDE systems, and list the required input data and steps for calibration. We give conditions under which a local volatility can exist given European option prices, stochastic interest rate model parameters, and correlations. The models are posed in a foreign exchange setting. The drift term for the exchange rate is given as a difference of two stochastic short rates, domestic and foreign, each modeled by a G1++ process. For stochastic volatility, we model the variance for the exchange rate by a CIR process. We include tests to show the convergence and the accuracy of the proposed algorithms.
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Cited in
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- Inverting the Markovian projection, with an application to local stochastic volatility models
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- A finite volume-alternating direction implicit approach for the calibration of stochastic local volatility models
- Calibration of local volatility using the local and implied instantaneous variance
- A novel Monte Carlo approach to hybrid local volatility models
- Convergence of an Euler scheme for a hybrid stochastic-local volatility model with stochastic rates in foreign exchange markets
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- Calibration of local‐stochastic volatility models by optimal transport
- Effective stochastic local volatility models
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- Joint calibration of local volatility models with stochastic interest rates using semimartingale optimal transport
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