Pricing timer options and variance derivatives with closed-form partial transform under the 3/2 model. Issue 5 (2nd September 2016)

• Record Type: Journal Article
• Authors: Zheng, Wendong; Zeng, Pingping
• Is Part Of: Applied mathematical finance. Volume 23:Issue 5(2016)
• Page Start: 344
• Page End: 373
• Publication Date: 2016-09-02
• Subjects: 3/2 model -- triple joint transition density -- timer options -- variance derivatives -- discrete monitoring; Business mathematics -- Periodicals; 650.0151
• DOI: 10.1080/1350486X.2017.1285242
• Languages: English
• ISSNs: 1350-486X

Abstract

ABSTRACT: Most of the empirical studies on stochastic volatility dynamics favour the 3/2 specification over the square-root (CIR) process in the Heston model. In the context of option pricing, the 3/2 stochastic volatility model (SVM) is reported to be able to capture the volatility skew evolution better than the Heston model. In this article, we make a thorough investigation on the analytic tractability of the 3/2 SVM by proposing a closed-form formula for the partial transform of the triple joint transition density( X, I, V ) which stand for the log asset price, the quadratic variation (continuous realized variance) and the instantaneous variance, respectively. Two distinct formulations are provided for deriving the main result. The closed-form partial transform enables us to deduce a variety of marginal partial transforms and characteristic functions and plays a crucial role in pricing discretely sampled variance derivatives and exotic options that depend on both the asset price and quadratic variation. Various applications and numerical examples on pricing moment swaps and timer options with discrete monitoring feature are given to demonstrate the versatility of the partial transform under the 3/2 model.