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Exponentiation of conditional expectations under stochastic volatility

Author

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  • Elisa Alòs
  • Jim Gatheral
  • Radoš Radoičić

Abstract

We use the Itô Decomposition Formula (see Alòs [A decomposition formula for option prices in the Heston model and applications to option pricing approximation. Finance Stoch., 2012, 16(3), 403–422]) to express certain conditional expectations as exponentials of iterated integrals. As one application, we compute an exact formal expression for the leverage swap for any stochastic volatility model expressed in forward variance form. As another, we show how to derive a smile expansion analogous to that of Bergomi and Guyon to all orders. Finally, we compute exact expressions under rough volatility, obtaining in particular the fractional Riccati equation for the rough Heston characteristic function. As a corollary, we compute a closed-form expression for the leverage swap in the rough Heston model which can be used for fast calibration.

Suggested Citation

  • Elisa Alòs & Jim Gatheral & Radoš Radoičić, 2020. "Exponentiation of conditional expectations under stochastic volatility," Quantitative Finance, Taylor & Francis Journals, vol. 20(1), pages 13-27, January.
    • Handle: RePEc:taf:quantf:v:20:y:2020:i:1:p:13-27
    DOI: 10.1080/14697688.2019.1642506
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    Citations

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    Cited by:

    1. Alessandro Bondi & Sergio Pulido & Simone Scotti, 2022. "The rough Hawkes Heston stochastic volatility model," Working Papers hal-03827332, HAL.
    2. Peter Friz & Jim Gatheral, 2022. "Diamonds and forward variance models," Papers 2205.03741, arXiv.org.
    3. Christa Cuchiero & Sara Svaluto-Ferro & Josef Teichmann, 2023. "Signature SDEs from an affine and polynomial perspective," Papers 2302.01362, arXiv.org.
    4. Giorgia Callegaro & Martino Grasselli & Gilles Paèes, 2021. "Fast Hybrid Schemes for Fractional Riccati Equations (Rough Is Not So Tough)," Mathematics of Operations Research, INFORMS, vol. 46(1), pages 221-254, February.
    5. Alessandro Bondi & Sergio Pulido & Simone Scotti, 2022. "The rough Hawkes Heston stochastic volatility model," Papers 2210.12393, arXiv.org.
    6. Peter K. Friz & Jim Gatheral, 2024. "Computing the SSR," Papers 2406.16131, arXiv.org.
    7. Siow Woon Jeng & Adem Kiliçman, 2021. "SPX Calibration of Option Approximations under Rough Heston Model," Mathematics, MDPI, vol. 9(21), pages 1-11, October.
    8. Siow Woon Jeng & Adem Kilicman, 2020. "Series Expansion and Fourth-Order Global Padé Approximation for a Rough Heston Solution," Mathematics, MDPI, vol. 8(11), pages 1-26, November.

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