WORST-OF OPTIONS AND CORRELATION SKEW UNDER A STOCHASTIC CORRELATION FRAMEWORK

Jacinto Marabel Romo ()
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Jacinto Marabel Romo: BBVA, Vía de los Poblados s/n, 28033, Madrid, Spain;

International Journal of Theoretical and Applied Finance (IJTAF), 2012, vol. 15, issue 07, 1-32

Abstract: This article considers a multi-asset model based on Wishart processes that accounts for stochastic volatility and for stochastic correlations between the underlying assets, as well as between their volatilities. The model accounts for the existence of correlation term structure and correlation skew. The article shows that the Wishart specification can generate different patterns corresponding to the correlation skew for a wide range of correlation term structures.Another advantage of the model is that it is analytically tractable and, hence, it is possible to obtain semi-closed-form solutions for the prices of plain vanilla options, as well as for the price of exotic derivatives. In this sense, this article develops semi-closed-form formulas for the price of European worst-of options with barriers and/or forward-start features. To motivate the introduction of the Wishart volatility model, the article compares the prices obtained under this model and under a multi-asset stochastic volatility model with constant instantaneous correlations. The results reveal the existence of a stochastic correlation premium and show that the consideration of stochastic correlation is a key element for the valuation of these structures.

Keywords: Wishart process; stochastic volatility; stochastic correlation; skew of correlation; worst-of options; forward-start options (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (2)

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DOI: 10.1142/S0219024912500513

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