12 Pages Posted: 15 Apr 2014 Last revised: 11 Sep 2014
Date Written: September 10, 2014
So far, path-dependent volatility models have drawn little attention from both practitioners and academics compared to local volatility and stochastic volatility models. This is unfair: in this article we show that they combine benefits from both. Like the local volatility model, they are complete and can fit exactly the market smile; like stochastic volatility models, they can produce rich implied volatility dynamics. Not only that: given their huge flexibility, they can actually generate a much broader range of spot-vol dynamics, thus possibly preventing large mispricings, and they can also capture prominent historical patterns of volatility. We give many examples to showcase their capabilities.
Keywords: Option pricing, path-dependent volatility, complete models, smile calibration, particle method, implied volatility dynamics, ARCH/GARCH models
JEL Classification: G13
Suggested Citation: Suggested Citation