Collocating Volatility: A Competitive Alternative to Stochastic Local Volatility Models

Anthonie W. van der Stoep, Lech A. Grzelak, Cornelis W. Oosterlee

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Abstract

We discuss a competitive alternative to stochastic local volatility models, namely the Collocating Volatility (CV) framework, introduced in [L. A. Grzelak (2019) The CLV framework-A fresh look at efficient pricing with smile, International Journal of Computer Mathematics 96 (11), 2209-2228]. The CV framework consists of two elements, a "kernel process"that can be efficiently evaluated and a local volatility function. The latter, based on stochastic collocation-e.g. [I. Babuška, F. Nobile & R. Tempone (2007) A stochastic collocation method for elliptic partial differential equations with random input data, SIAM Journal on Numerical Analysis 45 (3), 1005-1034; B. Ganapathysubramanian & N. Zabaras (2007) Sparse grid collocation schemes for stochastic natural convection problems, Journal of Computational Physics 225 (1), 652-685; J. A. S. Witteveen & G. Iaccarino (2012) Simplex stochastic collocation with random sampling and extrapolation for nonhypercube probability spaces, SIAM Journal on Scientific Computing 34 (2), A814-A838; D. Xiu & J. S. Hesthaven (2005) High-order collocation methods for differential equations with random inputs, SIAM Journal on Scientific Computing 27 (3), 1118-1139]-connects the kernel process to the market and allows the CV framework to be perfectly calibrated to European-type options. In this paper, we consider three different kernel process choices: The Ornstein-Uhlenbeck (OU) and Cox-Ingersoll-Ross (CIR) processes and the Heston model. The kernel process controls the forward smile and allows for an accurate and efficient calibration to exotic options, while the perfect calibration to liquid market quotes is preserved. We confirm this by numerical experiments, in which we calibrate the OU-CV, CIR-CV and Heston-CV frameworks to FX barrier options.

Original languageEnglish
Article number2050038
Pages (from-to)2050038-1 - 2050038-42
Number of pages42
JournalInternational Journal of Theoretical and Applied Finance
Volume23
Issue number6
DOIs
Publication statusPublished - 2020

Bibliographical note

Accepted author manuscript

Keywords

  • barrier options
  • calibration
  • Collocating volatility
  • forward volatility
  • Monte Carlo
  • stochastic collocation
  • stochastic local volatility

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