Pricing Forward Skew Dependent Derivatives: Multifactor Versus Single-Factor Stochastic Volatility Models

Journal of Futures Markets (2014), 34, 124-144.

29 Pages Posted: 1 Mar 2013 Last revised: 7 Jan 2014

See all articles by Jacinto Marabel Romo

Jacinto Marabel Romo

Grupo Banco Bilbao Vizcaya Argentaria (BBVA); Department of Management Sciences, University of Alcalá

Date Written: November 1, 2012

Abstract

Empirical evidence shows that, in equity options markets, the slope of the skew is largely independent of the volatility level. Single-factor stochastic volatility models are not flexible enough to account for the stochastic behavior of the skew. On the other hand, multifactor stochastic volatility models are able to account for the existence of stochastic skew. This study studies the effects of introducing stochastic skew in the valuation of forward skew dependent exotic options. In particular, I consider cliquet, as well as reverse cliquet structures. The study also derives a semi-closed-form solution for the price of forward-start options under the multifactor stochastic specification.

The empirical results indicate that the consideration of additional volatility factors in the context of stochastic volatility models allows us to generate more flexible smile patterns. This additional flexibility has a relevant impact on the valuation of forward skew dependent derivatives. In this sense, this study shows that similar calibrations of single factor and multifactor stochastic volatility models to the current market prices of plain vanilla options can lead to important discrepancies in the pricing of exotic forward skew dependent derivatives such as regular cliquet structures and reverse cliquet options.

Keywords: stochastic volatility, multifactor, stochastic skew, forward start options

JEL Classification: G1, G2, G12, G13

Suggested Citation

Marabel Romo, Jacinto, Pricing Forward Skew Dependent Derivatives: Multifactor Versus Single-Factor Stochastic Volatility Models (November 1, 2012). Journal of Futures Markets (2014), 34, 124-144., Available at SSRN: https://ssrn.com/abstract=2225815

Jacinto Marabel Romo (Contact Author)

Grupo Banco Bilbao Vizcaya Argentaria (BBVA) ( email )

c/ Sauceda, 28
Madrid
Spain

Department of Management Sciences, University of Alcalá ( email )

Plaza de la Victoria s/n
Alcala de Henares, Madrid 28802
Spain

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