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Correction to Black-Scholes formula due to fractional stochastic volatility

Josselin Garnier and Knut Solna

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Abstract: Empirical studies show that the volatility may exhibit correlations that decay as a fractional power of the time offset. The paper presents a rigorous analysis for the case when the stationary stochastic volatility model is constructed in terms of a fractional Ornstein Uhlenbeck process to have such correlations. It is shown how the associated implied volatility has a term structure that is a function of maturity to a fractional power.

Date: 2015-09, Revised 2017-03
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Handle: RePEc:arx:papers:1509.01175