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Rescaling the double-mean-reverting 4/2 stochastic volatility model for derivative pricing

Jiling Cao, Jeong-Hoon Kim, Wenqiang Liu and Wenjun Zhang

Finance Research Letters, 2023, vol. 58, issue PB

Abstract: The popular 4/2 stochastic volatility model reveals important features of volatility but a closed-form formula for derivative prices is still lacking. This paper proposes a modified form of the 4/2 model into which two scale double-mean-reverting stochastic volatility is incorporated in order to remedy its shortcomings. We obtain a closed-form formula for the prices of European derivatives. The formula can be explicitly calculated by taking derivatives of the Black–Scholes prices and thus faster calibration of the 4/2 model becomes available. We also show that the rescaled 4/2 model is flexible enough to capture essential features (skew or smile) of market implied volatilities.

Keywords: 4/2 stochastic volatility; Double-mean-reversion; Closed-form formula; Derivative; Implied volatility (search for similar items in EconPapers)
JEL-codes: C22 C65 G12 G13 (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finlet:v:58:y:2023:i:pb:s1544612323007468

DOI: 10.1016/j.frl.2023.104374

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