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Rough PDEs for local stochastic volatility models

Author

Listed:
  • Peter Bank
  • Christian Bayer
  • Peter K. Friz
  • Luca Pelizzari
Abstract
In this work, we introduce a novel pricing methodology in general, possibly non-Markovian local stochastic volatility (LSV) models. We observe that by conditioning the LSV dynamics on the Brownian motion that drives the volatility, one obtains a time-inhomogeneous Markov process. Using tools from rough path theory, we describe how to precisely understand the conditional LSV dynamics and reveal their Markovian nature. The latter allows us to connect the conditional dynamics to so-called rough partial differential equations (RPDEs), through a Feynman-Kac type of formula. In terms of European pricing, conditional on realizations of one Brownian motion, we can compute conditional option prices by solving the corresponding linear RPDEs, and then average over all samples to find unconditional prices. Our approach depends only minimally on the specification of the volatility, making it applicable for a wide range of classical and rough LSV models, and it establishes a PDE pricing method for non-Markovian models. Finally, we present a first glimpse at numerical methods for RPDEs and apply them to price European options in several rough LSV models.

Suggested Citation

  • Peter Bank & Christian Bayer & Peter K. Friz & Luca Pelizzari, 2023. "Rough PDEs for local stochastic volatility models," Papers 2307.09216, arXiv.org.
    • Handle: RePEc:arx:papers:2307.09216
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    References listed on IDEAS

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    1. Christian Bayer & Peter K. Friz & Paul Gassiat & Jorg Martin & Benjamin Stemper, 2020. "A regularity structure for rough volatility," Mathematical Finance, Wiley Blackwell, vol. 30(3), pages 782-832, July.
    2. Ofelia Bonesini & Antoine Jacquier & Alexandre Pannier, 2023. "Rough volatility, path-dependent PDEs and weak rates of convergence," Papers 2304.03042, arXiv.org.
    3. Marc Romano & Nizar Touzi, 1997. "Contingent Claims and Market Completeness in a Stochastic Volatility Model," Mathematical Finance, Wiley Blackwell, vol. 7(4), pages 399-412, October.
    4. Christian Bayer & Chiheb Ben Hammouda & Raúl Tempone, 2023. "Numerical smoothing with hierarchical adaptive sparse grids and quasi-Monte Carlo methods for efficient option pricing," Quantitative Finance, Taylor & Francis Journals, vol. 23(2), pages 209-227, February.
    5. Christian Bayer & Peter Friz & Jim Gatheral, 2016. "Pricing under rough volatility," Quantitative Finance, Taylor & Francis Journals, vol. 16(6), pages 887-904, June.
    6. Christian Bayer & Eric Joseph Hall & Raãšl Tempone, 2022. "Weak Error Rates For Option Pricing Under Linear Rough Volatility," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 25(07n08), pages 1-47, November.
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    Cited by:

    1. Ulrich Horst & Wei Xu & Rouyi Zhang, 2023. "Convergence of Heavy-Tailed Hawkes Processes and the Microstructure of Rough Volatility," Papers 2312.08784, arXiv.org, revised Nov 2024.

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