On refined volatility smile expansion in the Heston model

DOI10.1080/14697688.2010.541486zbMATH Open1267.91068arXiv1001.3003OpenAlexW2054646230MaRDI QIDQ5300441FDOQ5300441

Authors: Peter Friz, Stefan Gerhold, Archil Gulisashvili, Stephan Sturm 

Publication date: 27 June 2013

Published in: Quantitative Finance (Search for Journal in Brave)

Abstract: It is known that Heston's stochastic volatility model exhibits moment explosion, and that the critical moment $s_{+}$ can be obtained by solving (numerically) a simple equation. This yields a leading order expansion for the implied volatility at large strikes: $sigm{a}_{BS}(k,T{)}^{2}TsimPsi(s_{+}-1)imesk$ (Roger Lee's moment formula). Motivated by recent "tail-wing" refinements of this moment formula, we first derive a novel tail expansion for the Heston density, sharpening previous work of Dragulescu and Yakovenko [Quant. Finance 2, 6 (2002), 443--453], and then show the validity of a refined expansion of the type $$, where all constants are explicitly known as functions of $s_{+}$, the Heston model parameters, spot vol and maturity $T$. In the case of the "zero-correlation" Heston model such an expansion was derived by Gulisashvili and Stein [Appl. Math. Optim. 61, 3 (2010), 287--315]. Our methods and results may prove useful beyond the Heston model: the entire quantitative analysis is based on affine principles: at no point do we need knowledge of the (explicit, but cumbersome) closed form expression of the Fourier transform of $log{S}_T$ (equivalently: Mellin transform of $S_T$ ); what matters is that these transforms satisfy ordinary differential equations of Riccati type. Secondly, our analysis reveals a new parameter ("critical slope"), defined in a model free manner, which drives the second and higher order terms in tail- and implied volatility expansions.

Full work available at URL: https://arxiv.org/abs/1001.3003

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zbMATH Keywords

differential equationsstochastic volatilityderivatives pricingvolatility smile fitting

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20)

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Cited In (25)

• The large-maturity smile for the Heston model
• Asymptotic equivalence in Lee's moment formulas for the implied volatility, asset price models without moment explosions, and Piterbarg's conjecture
• Asymptotics of implied volatility to arbitrary order
• On Singularities in the Heston Model
• Asymptotic Expansion Approach in Finance
• Two-Sided Estimates for Distribution Densities in Models with Jumps
• Large-maturity regimes of the Heston forward smile
• Series Expansions and Direct Inversion for the Heston Model
• The complete Gaussian kernel in the multi-factor Heston model: option pricing and implied volatility applications
• Asymptotic Analysis of Stock Price Densities and Implied Volatilities in Mixed Stochastic Models
• Asymptotics of Forward Implied Volatility
• Generalized arbitrage-free SVI volatility surfaces
• Marginal Density Expansions for Diffusions and Stochastic Volatility I: Theoretical Foundations
• Parametric modeling of implied smile functions: a generalized SVI model
• Difference Equation Theory Meets Mathematical Finance
• Local Volatility, Conditioned Diffusions, and Varadhan's Formula
• How to make Dupire’s local volatility work with jumps
• Shapes of Implied Volatility with Positive Mass at Zero
• The term structure of implied volatility in symmetric models with applications to Heston
• Extreme-Strike Comparisons and Structural Bounds for SPX and VIX Options
• Marginal Density Expansions for Diffusions and Stochastic Volatility II: Applications
• From Moment Explosion to the Asymptotic Behavior of the Cumulative Distribution for a Random Variable
• Extrapolation Analytics for Dupire’s Local Volatility
• Small-Maturity Asymptotics for the At-The-Money Implied Volatility Slope in Lévy Models
• Moment explosions in the rough Heston model

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