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A stochastic-local volatility model with Le´vy jumps for pricing derivatives

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  • Kim, Hyun-Gyoon
  • Kim, Jeong-Hoon

Abstract

We introduce a new mixed model unifying local volatility, pure stochastic volatility, and Le´vy type of jumps in this paper. Our model framework allows the pure stochastic volatility and the jump intensity to be functions of fast (and slowly) varying stochastic processes and the local volatility to be given in a constant elasticity of variance type of parametric form. We use asymptotic analysis to derive a system of partial integro-differential equations for the prices of European derivatives and use Fourier analysis to obtain an explicit formula for the prices. Our result is an extension of a stochastic-local volatility model from no jumps to Le´vy jumps and an extension of a multiscale stochastic volatility model with Le´vy jumps from the zero elasticity of variance to the non-zero elasticity of variance. We find that our model outperforms two benchmark models in view of fitting performance when the time-to-maturities of European options are relatively short and outperforms one benchmark model in terms of pricing time cost.

Suggested Citation

  • Kim, Hyun-Gyoon & Kim, Jeong-Hoon, 2023. "A stochastic-local volatility model with Le´vy jumps for pricing derivatives," Applied Mathematics and Computation, Elsevier, vol. 451(C).
    • Handle: RePEc:eee:apmaco:v:451:y:2023:i:c:s0096300323002035
    DOI: 10.1016/j.amc.2023.128034
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