Analysis of an uncertain volatility model.pdfVIP

ANALYSIS OF AN UNCERTAIN VOLATILITY MODEL MARCO DI FRANCESCO, PAOLO FOSCHI, AND ANDREA PASCUCCI Received 11 January 2006; Revised 4 September 2006; Accepted 6 September 2006 We examine, from both analytical and numerical viewpoints, the uncertain volatility model by Hobson-Rogers in the framework of degenerate parabolic PDEs of Kolmogorov type. Copyright © 2006 Marco Di Francesco et al. This is an open access article distributed un- der the Creative Commons Attribution License, which permits unrestricted use, distribu- tion, and reproduction in any medium, provided the original work is properly cited. 1. Introduction Several extensions of the Black-Scholes model [3] have appeared in the literature (see, for a survey, Epps [6]) aiming to capture the characteristic observed patterns of the im- plied volatility given by the market. Here we are concerned with the seemingly promising model proposed by Hobson and Rogers [8] who assume that the volatility is a determin- istic function of the history of the spot process. The merit of the model is twofold: first, it is potentially able to reproduce smiles, skews of different directions, and volatility term structures. Second, it preserves the completeness of the market since no exogenous source of risk is added, so that the classical arbitrage pricing and hedging theory apply. In par- ticular, there are unique preference-independent prices for claims given in terms of the expectation under an equivalent martingale measure or as solutions to a PDE in three variables. Indeed incorporating the dependence on past prices entails an additional state variable on which the derivative’s price depends: then, as in the case of Asian or look-back options, the associated PDE is of degenerate parabolic type. In this paper we focus on the analytical and numerical treatment of the Hobson- Rogers model in the framework of Kolmogorov PDEs. Degenerate equations of Kolmog- orov type naturally a