On small-noise equations with degenerate limiting system arising from volatility models

DOI10.1007/978-3-319-11605-1_17MaRDI QIDQ4560342zbMATHOpenAlexFDO

Authors Giovanni Conforti, Stefano De Marco, Jean-Dominique Deuschel

Publication date 11 December 2018

Published in Springer Proceedings in Mathematics & Statistics (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1404.4464

zbMATH Keywords

large deviationsCIR processdegenerate diffusionstail asymptoticsFreidlin-Wentzellpathwise large deviationssquare-root diffusions

Mathematics Subject Classification ID

Large deviations (60F10) Stochastic ordinary differential equations (aspects of stochastic analysis) (60H10) Interest rates, asset pricing, etc. (stochastic models) (91G30) Financial applications of other theories (91G80)

Abstract: The one-dimensional SDE with non Lipschitz diffusion coefficient $d{X}_t=b(X_t)dt+sigma{X}_t^{gamma}d{B}_t,X_0=x,gamma<1$ is widely studied in mathematical finance. Several works have proposed asymptotic analysis of densities and implied volatilities in models involving instances of this equation, based on a careful implementation of saddle-point methods and (essentially) the explicit knowledge of Fourier transforms. Recent research on tail asymptotics for heat kernels [J-D. Deuschel, P.~Friz, A.~Jacquier, and S.~Violante. Marginal density expansions for diffusions and stochastic volatility, part II: Applications. 2013, arxiv:1305.6765] suggests to work with the rescaled variable $X^{varepsilon}:=varepsilo{n}^{1/(1-gamma)}X$: while allowing to turn a space asymptotic problem into a small-$varepsilon$ problem with fixed terminal point, the process $X^{varepsilon}$ satisfies a SDE in Wentzell--Freidlin form (i.e. with driving noise $varepsilondB$). We prove a pathwise large deviation principle for the process $X^{varepsilon}$ as $varepsilono0$. As it will become clear, the limiting ODE governing the large deviations admits infinitely many solutions, a non-standard situation in the Wentzell--Freidlin theory. As for applications, the $varepsilon$-scaling allows to derive exact log-asymptotics for path functionals of the process: while on the one hand the resulting formulae are confirmed by the CIR-CEV benchmarks, on the other hand the large deviation approach (i) applies to equations with a more general drift term and (ii) potentially opens the way to heat kernel analysis for higher-dimensional diffusions involving such an SDE as a component.

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Cited in

(6)

• Large deviation principles for stochastic volatility models with reflection
• Large-maturity regimes of the Heston forward smile
• Gaussian stochastic volatility models: scaling regimes, large deviations, and moment explosions
• Multilevel Monte Carlo for stochastic differential equations with small noise
• Large and moderate deviations for stochastic Volterra systems
• Time-inhomogeneous Gaussian stochastic volatility models: large deviations and super roughness

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