Analytical Formulas for Local Volatility Model with Stochastic Rates

Abstract

This paper presents new approximation formulae of European options in a local volatility model with stochastic interest rates. This is a companion paper to our work on perturbation methods for local volatility models http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1275872 for the case of stochastic interest rates. The originality of this approach is to model the local volatility of the discounted spot and to obtain accurate approximations with tight estimates of the error terms. This approach can also be used in the case of stochastic dividends or stochastic convenience yields. We finally provide numerical results to illustrate the accuracy with real market data.

Keywords: asymptotic expansion, local volatility model, HJM framework, Hull and White model, Malliavin calculus, small diffusion process, CEV model

JEL Classification: G13