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Short-time at-the-money skew and rough fractional volatility

Masaaki Fukasawa

Quantitative Finance, 2017, vol. 17, issue 2, 189-198

Abstract: The Black–Scholes implied volatility skew at the money of SPX options is known to obey a power law with respect to the time to maturity. We construct a model of the underlying asset price process which is dynamically consistent to the power law. The volatility process of the model is driven by a fractional Brownian motion with Hurst parameter less than half. The fractional Brownian motion is correlated with a Brownian motion which drives the asset price process. We derive an asymptotic expansion of the implied volatility as the time to maturity tends to zero. For this purpose, we introduce a new approach to validate such an expansion, which enables us to treat more general models than in the literature. The local-stochastic volatility model is treated as well under an essentially minimal regularity condition in order to show such a standard model cannot be dynamically consistent to the power law.

Date: 2017
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Handle: RePEc:taf:quantf:v:17:y:2017:i:2:p:189-198