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A chaos expansion approach under hybrid volatility models

Hideharu Funahashi

Quantitative Finance, 2014, vol. 14, issue 11, 1923-1936

Abstract: In this paper, we propose an approximation method based on the Wiener-Ito chaos expansion for the pricing of European contingent claims. Our method is applicable to widely used option pricing models such as local volatility models, stochastic volatility models and their combinations. This method is useful in practice since the resulting approximation formula is not computationally expensive, hence it is suitable for calibration purposes. We will show through some numerical examples that our approximation remains quite good even for the long maturity and/or the high volatility cases, which is a desired feature. As an example, we propose a hybrid volatility model and apply our approximation formula to the JPY/USD currency option market obtaining very accurate results.

Date: 2014
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