Why are quadratic normal volatility models analytically tractable?

DOI10.1137/120871973MaRDI QIDQ2873123zbMATH OpenOpenAlexFDO

Authors Peter Carr, Travis Fisher, Johannes Ruf

Publication date 23 January 2014

Published in SIAM Journal on Financial Mathematics (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1202.6187

zbMATH Keywords

change of numéraireforeign exchangehyperinflationlocal martingalelocal volatilitypricingRiccati equationsemistatic hedging

Mathematics Subject Classification ID

Applications of stochastic analysis (to PDEs, etc.) (60H30) Applications of Brownian motions and diffusion theory (population genetics, absorption problems, etc.) (60J70) Stochastic models in economics (91B70) Derivative securities (option pricing, hedging, etc.) (91G20) Actuarial science and mathematical finance (91G99)

Abstract: We discuss the class of "Quadratic Normal Volatility" models, which have drawn much attention in the financial industry due to their analytic tractability and flexibility. We characterize these models as the ones that can be obtained from stopped Brownian motion by a simple transformation and a change of measure that only depends on the terminal value of the stopped Brownian motion. This explains the existence of explicit analytic formulas for option prices within Quadratic Normal Volatility models in the academic literature.

Review text

The paper focuses on quadratic normal volatility (QNV) models, in light of their applications within the financial context. After a brief introduction to QNV models, the study investigates how such models can be obtained by a stopped Brownian motion. Then, connections between QNV models and geometric Brownian motion are investigated, as well as their stability under changes of numéraires. Moreover, results on semistatic hedging are provided. Finally, the financial interpretation of certain QNV processes is discussed.

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Cited in

(10)

• Lie symmetry methods for local volatility models
• Asymptotic expansion for some local volatility models arising in finance
• Distribution of the time to explosion for one-dimensional diffusions
• Numerical approximation of irregular SDEs via Skorokhod embeddings
• A general valuation framework for SABR and stochastic local volatility models
• On the hedging of options on exploding exchange rates
• Pricing of vanilla and first-generation exotic options in the local stochastic volatility framework: survey and new results
• Financial models with defaultable numéraires
• Uniqueness in Cauchy problems for diffusive real-valued strict local martingales
• Supermartingales as Radon-Nikodym densities and related measure extensions

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