Capturing implied correlation skew from options prices via multiscale stochastic volatility models

T. Pellegrino ()
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T. Pellegrino: MET Market Risk Team, MET International AG, Baarerstrasse 141, 6300, Zug, Switzerland

International Journal of Financial Engineering (IJFE), 2020, vol. 07, issue 04, 1-42

Abstract: The aim of this paper is to derive a second-order asymptotic expansion for the price of European options written on two underlying assets, whose dynamics are described by multiscale stochastic volatility models. In particular, the second-order expansion of option prices can be translated into a corresponding expansion in implied correlation units. The resulting approximation for the implied correlation curve turns out to be quadratic in the log-moneyness, capturing the convexity of the implied correlation skew. Finally, we describe a calibration procedure where the model parameters can be estimated using option prices on individual underlying assets.

Keywords: Correlation skew; Stochastic volatility; asymptotic analysis; singular-regular perturbation theory (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1142/S2424786320500425

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