The Characteristic Function of Rough Heston Models

36 Pages Posted: 11 Jan 2019

See all articles by Omar El Euch

Omar El Euch

Ecole Polytechnique, Paris

Mathieu Rosenbaum

Ecole Polytechnique, Palaiseau

Date Written: January 2019

Abstract

It has been recently shown that rough volatility models, where the volatility is driven by a fractional Brownian motion with small Hurst parameter, provide very relevant dynamics in order to reproduce the behavior of both historical and implied volatilities. However, due to the non‐Markovian nature of the fractional Brownian motion, they raise new issues when it comes to derivatives pricing. Using an original link between nearly unstable Hawkes processes and fractional volatility models, we compute the characteristic function of the log‐price in rough Heston models. In the classical Heston model, the characteristic function is expressed in terms of the solution of a Riccati equation. Here, we show that rough Heston models exhibit quite a similar structure, the Riccati equation being replaced by a fractional Riccati equation.

Keywords: fractional Brownian motion, fractional Riccati equation, Hawkes processes, limit theorems, rough Heston models, rough volatility models

Suggested Citation

El Euch, Omar and Rosenbaum, Mathieu, The Characteristic Function of Rough Heston Models (January 2019). Mathematical Finance, Vol. 29, Issue 1, pp. 3-38, 2019. Available at SSRN: https://ssrn.com/abstract=3313646 or http://dx.doi.org/10.1111/mafi.12173

Omar El Euch (Contact Author)

Ecole Polytechnique, Paris ( email )

1 rue Descartes
Paris, 75005
France

Mathieu Rosenbaum

Ecole Polytechnique, Palaiseau ( email )

Route de Saclay
Palaiseau, 91128
France

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