Existence of a calibrated regime switching local volatility model. (18th November 2019)

• Record Type: Journal Article
• Authors: Jourdain, Benjamin; Zhou, Alexandre
• Is Part Of: Mathematical finance. Volume 30:Number 2(2020)
• Page Start: 501
• Page End: 546
• Publication Date: 2019-11-18
• Subjects: calibration -- diffusions nonlinear in the sense of McKean -- Dupire's local volatility -- Fokker–Planck systems -- local and stochastic volatility models; Business mathematics -- Periodicals; 332
• DOI: 10.1111/mafi.12231
• Languages: English
• ISSNs: 0960-1627

Abstract

Abstract: By Gyöngy's theorem, a local and stochastic volatility model is calibrated to the market prices of all European call options with positive maturities and strikes if its local volatility (LV) function is equal to the ratio of the Dupire LV function over the root conditional mean square of the stochastic volatility factor given the spot value. This leads to a stochastic differential equation (SDE) nonlinear in the sense of McKean. Particle methods based on a kernel approximation of the conditional expectation, as presented in Guyon and Henry‐Labordère [ Risk Magazine, 25, 92–97], provide an efficient calibration procedure even if some calibration errors may appear when the range of the stochastic volatility factor is very large. But so far, no global existence result is available for the SDE nonlinear in the sense of McKean. When the stochastic volatility factor is a jump process taking finitely many values and with jump intensities depending on the spot level, we prove existence of a solution to the associated Fokker–Planck equation under the condition that the range of the squared stochastic volatility factor is not too large. We then deduce existence to the calibrated model by extending the results in Figalli [ Journal of Functional Analysis, 254 (1), 109–153].