Pricing Forward Start Options in Models Based on (Time-Changed) Levy Processes

Abstract

Options depending on the forward skew are very popular. One such option is the forward starting call option - the basic building block of a cliquet option. Widely applied models to account for the forward skew dynamics to price such options include the Heston model, the Heston-Hull-White model and the Bates model. Within these models solutions for options including forward start features are available using (semi) analytical formulas.

Today exponential (subordinated) Levy models being increasingly popular for modelling the asset dynamics. While the simple exponential Levy models imply the same forward volatily surface for all future times the subordinated models do not. Depending on the subordinator the dynamic of the forward volatility surface and therefore stochastic volatility can be modelled.

Analytical pricing formulas based on the characteristic function and Fourier transform methods are available for the class of these models.

We extend the applicability of analytical pricing to options including forward start features. To this end we derive the forward characteristic functions which can be used in Fourier transform based methods.

As examples we consider the Variance Gamma model and the NIG model subordinated by a Gamma Ornstein Uhlenbeck process and respectively by an Cox-Ingersoll-Ross process. We check our analytical results by applying Monte Carlo methods. These results can for instance be applied to calibration of the forward volatility surface.

Keywords: Variance Gamma, Normal Inverse Gaussian, Gamma Ornstein Uhlenbeck, CIR, Subordinator, Time change, forward characteristic function, Option Pricing

JEL Classification: G10, G12, G13