Large Deviations and Stochastic Volatility with Jumps: Asymptotic Implied Volatility for Affine Models

Abstract

We show that the implied volatility has a uniform (in log moneyness x) limit as the maturity tends to infinity, given by an explicit closed-form formula, for x in some compact neighborhood of zero in the class of affine stochastic volatility models. This expression is function of the convex dual of the limiting cumulant generating function h of the scaled log-spot process. We express h in terms of the functional characteristics of the underlying model. The proof of the limiting formula rests on the large deviation behavior of the scaled log-spot process as time tends to infinity. We apply our results to obtain the limiting smile for several classes of stochastic volatility models with jumps used in applications (e.g. Heston with state-independent jumps, Bates with state-dependent jumps and Barndorff-Nielsen-Shephard model).

Keywords: large deviation principle, stochastic volatility with jumps, affine processes, implied volatility in the large maturity limit

JEL Classification: 60G44, 60F10, 91G20