Applications of Fourier transform to smile modeling. Theory and implementation. (Q1022284)

The book is intended to present a comprehensive treatment of the Fourier transform in option pricing, covering the most stochastic factors, such as stochastic volatilities, stochastic interest rates, Poisson and Lévy jumps. It is aimed at graduate students and researchers looking for a compact introduction to smile modeling with Fourier transform, or to financial engineers and risk managers working on option pricing and willing to implement models with characteristic functions. The book is organized in a self-contained style, presenting the basic concepts of option pricing theory and the advanced techniques of asset modeling, especially with respect to Fourier transform and characteristic functions. The book is structured on 11 chapters. Chapter 1 summarizes the Black-Scholes option valuation model and explains the related smile effect of implied volatilities. Chapter 2 deals with the fundamentals of option pricing using characteristic functions. Here, the author gives economical and mathematical motivations for using the Fourier transform as a pricing technique. The third chapter considers stochastic volatility models that play a crucial role in smile modeling, from both the theoretical and the practical point of view. The models discussed here are: the Heston model, the Schöbel and Zhu model and a double square root model. In chapter 4, the numerical implementation of these models is discussed. The numerical issues addressed here are, among others, the efficient numerical integration of inverse Fourier transform, the complex logarithms, the calculation of the Greeks or quick calibration to market data. Chapter 5 focuses on the simulation of stochastic volatility models. Some recently developed efficient simulation methods for the Heston model are presented here. Chapter 6 explains how to incorporate stochastic interest rates into an option pricing model in a short rate setup. The models under examination are: the Cox-Ingersoll-Ross model, the Longstaff model and the Vasicek model. The first two models are discussed in the cases of zero or non-zero correlation between the stock returns and the interest rates. Chapters 7 and 8 are dedicated to jump modeling. In chapter 7, Poisson jumps are considered, while chapter 8 deals with Lévy jumps. Chapter 9 integrates all the stochastic factors considered into a unified pricing framework. The approaches used for integration are: the modular approach and the time-change approach. Chapter 10 addresses the valuation of exotic options with stochastic factors, particularly with stochastic volatility. For some special processes and model setups, the author derived tractable pricing solutions for some exotic options, e.g., barrier options, correlation options, Asian options. The last chapter presents five stochastic volatility Libor market models that are applied to capture the smile effects in cap and swaption markets. All these models apply characteristic functions or moment generating functions for pricing caps and swaptions.