Calibration of the Heston stochastic local volatility model: A finite volume scheme

The two most popular equity and FX derivatives pricing models in banking practice are the local volatility model and the Heston model. While the former has the appealing property that it can be calibrated exactly to any given set of arbitrage free European vanilla option prices, the latter delivers more realistic smile dynamics. In this paper, we combine both modeling approaches to the Heston stochastic local volatility model. We build upon a theoretical framework that has been already developed and focus on the numerical model calibration which requires special care in the treatment of mixed derivatives and in cases where the Feller condition is not met in the Heston model leading to a singular transition density at zero volatility. We propose a finite volume scheme to calibrate the model after a suitable transformation of the model equation and demonstrate its accuracy in numerical test cases using real market data.

Nonparametric Malliavin–Monte Carlo Computation of Hedging Greeks

We propose a way to compute the hedging Delta using the Malliavin weight method. Our approach, which we name the λ-method, generally outperforms the standard Monte Carlo finite difference method, especially for discontinuous payoffs. Furthermore, our approach is nonparametric, as we only assume a general local volatility model and we substitute the volatility and the other processes involved in the Greek formula with quantities that can be nonparametrically estimated from a given time series of observed prices.

SMILE MODELING IN COMMODITY MARKETS

We present a stochastic local volatility model for derivative contracts on commodity futures able to describe forward curve and smile dynamics with a fast calibration to liquid market quotes. A parsimonious parametrization is introduced to deal with the limited number of options quoted in the market. Cleared commodity markets for futures and options are analyzed to include in the pricing framework-specific trading clauses and margining procedures. Numerical examples for calibration and pricing are provided for different commodity products.