# Stochastic volatility

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Stochastic volatility models are those in which the variance of a stochastic process is itself randomly distributed.[1] They are used in the field of mathematical finance to evaluate derivative securities, such as options. The name derives from the models' treatment of the underlying security's volatility as a random process, governed by state variables such as the price level of the underlying security, the tendency of volatility to revert to some long-run mean value, and the variance of the volatility process itself, among others.

Stochastic volatility models are one approach to resolve a shortcoming of the Black–Scholes model. In particular, models based on Black-Scholes assume that the underlying volatility is constant over the life of the derivative, and unaffected by the changes in the price level of the underlying security. However, these models cannot explain long-observed features of the implied volatility surface such as volatility smile and skew, which indicate that implied volatility does tend to vary with respect to strike price and expiry. By assuming that the volatility of the underlying price is a stochastic process rather than a constant, it becomes possible to model derivatives more accurately.

## Basic model

Starting from a constant volatility approach, assume that the derivative's underlying asset price follows a standard model for geometric Brownian motion:

${\displaystyle dS_{t}=\mu S_{t}\,dt+\sigma S_{t}\,dW_{t}\,}$

where ${\displaystyle \mu \,}$ is the constant drift (i.e. expected return) of the security price ${\displaystyle S_{t}\,}$, ${\displaystyle \sigma \,}$ is the constant volatility, and ${\displaystyle dW_{t}\,}$ is a standard Wiener process with zero mean and unit rate of variance. The explicit solution of this stochastic differential equation is

${\displaystyle S_{t}=S_{0}e^{(\mu -{\frac {1}{2}}\sigma ^{2})t+\sigma W_{t}}}$.

The Maximum likelihood estimator to estimate the constant volatility ${\displaystyle \sigma \,}$ for given stock prices ${\displaystyle S_{t}\,}$ at different times ${\displaystyle t_{i}\,}$ is

{\displaystyle {\begin{aligned}{\hat {\sigma }}^{2}&=\left({\frac {1}{n}}\sum _{i=1}^{n}{\frac {(\ln S_{t_{i}}-\ln S_{t_{i-1}})^{2}}{t_{i}-t_{i-1}}}\right)-{\frac {1}{n}}{\frac {(\ln S_{t_{n}}-\ln S_{t_{0}})^{2}}{t_{n}-t_{0}}}\\&={\frac {1}{n}}\sum _{i=1}^{n}(t_{i}-t_{i-1})\left({\frac {\ln {\frac {S_{t_{i}}}{S_{t_{i-1}}}}}{t_{i}-t_{i-1}}}-{\frac {\ln {\frac {S_{t_{n}}}{S_{t_{0}}}}}{t_{n}-t_{0}}}\right)^{2};\end{aligned}}}

This basic model with constant volatility ${\displaystyle \sigma \,}$ is the starting point for non-stochastic volatility models such as Black–Scholes model and Cox–Ross–Rubinstein model.

For a stochastic volatility model, replace the constant volatility ${\displaystyle \sigma \,}$ with a function ${\displaystyle \nu _{t}\,}$, that models the variance of ${\displaystyle S_{t}\,}$. This variance function is also modeled as brownian motion, and the form of ${\displaystyle \nu _{t}\,}$ depends on the particular SV model under study.

${\displaystyle dS_{t}=\mu S_{t}\,dt+{\sqrt {\nu _{t}}}S_{t}\,dW_{t}\,}$
${\displaystyle d\nu _{t}=\alpha _{S,t}\,dt+\beta _{S,t}\,dB_{t}\,}$

where ${\displaystyle \alpha _{S,t}\,}$ and ${\displaystyle \beta _{S,t}\,}$ are some functions of ${\displaystyle \nu \,}$ and ${\displaystyle dB_{t}\,}$ is another standard gaussian that is correlated with ${\displaystyle dW_{t}\,}$ with constant correlation factor ${\displaystyle \rho \,}$.

### Heston model

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The popular Heston model is a commonly used SV model, in which the randomness of the variance process varies as the square root of variance. In this case, the differential equation for variance takes the form:

${\displaystyle d\nu _{t}=\theta (\omega -\nu _{t})dt+\xi {\sqrt {\nu _{t}}}\,dB_{t}\,}$

where ${\displaystyle \omega }$ is the mean long-term volatility, ${\displaystyle \theta }$ is the rate at which the volatility reverts toward its long-term mean, ${\displaystyle \xi }$ is the volatility of the volatility process, and ${\displaystyle dB_{t}}$ is, like ${\displaystyle dW_{t}}$, a gaussian with zero mean and ${\displaystyle {\sqrt {dt}}}$ standard deviation. However, ${\displaystyle dW_{t}}$ and ${\displaystyle dB_{t}}$ are correlated with the constant correlation value ${\displaystyle \rho }$.

In other words, the Heston SV model assumes that the variance is a random process that

1. exhibits a tendency to revert towards a long-term mean ${\displaystyle \omega }$ at a rate ${\displaystyle \theta }$,
2. exhibits a volatility proportional to the square root of its level
3. and whose source of randomness is correlated (with correlation ${\displaystyle \rho }$) with the randomness of the underlying's price processes.

There exist few known parametrisation of the volatility surface based on the heston model (Schonbusher, SVI and gSVI) as well as their de-arbitraging methodologies.[2]

### CEV model

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The CEV model describes the relationship between volatility and price, introducing stochastic volatility:

${\displaystyle dS_{t}=\mu S_{t}\,dt+\sigma S_{t}^{\gamma }\,dW_{t}}$

Conceptually, in some markets volatility rises when prices rise (e.g. commodities), so ${\displaystyle \gamma >1}$. In other markets, volatility tends to rise as prices fall, modelled with ${\displaystyle \gamma <1}$.

Some argue that because the CEV model does not incorporate its own stochastic process for volatility, it is not truly a stochastic volatility model. Instead, they call it a local volatility model.

### SABR volatility model

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The SABR model (Stochastic Alpha, Beta, Rho) describes a single forward ${\displaystyle F}$ (related to any asset e.g. an index, interest rate, bond, currency or equity) under stochastic volatility ${\displaystyle \sigma }$:

${\displaystyle dF_{t}=\sigma _{t}F_{t}^{\beta }\,dW_{t},}$
${\displaystyle d\sigma _{t}=\alpha \sigma _{t}^{}\,dZ_{t},}$

The initial values ${\displaystyle F_{0}}$ and ${\displaystyle \sigma _{0}}$ are the current forward price and volatility, whereas ${\displaystyle W_{t}}$ and ${\displaystyle Z_{t}}$ are two correlated Wiener processes (i.e. Brownian motions) with correlation coefficient ${\displaystyle -1<\rho <1}$. The constant parameters ${\displaystyle \beta ,\;\alpha }$ are such that ${\displaystyle 0\leq \beta \leq 1,\;\alpha \geq 0}$.

The main feature of the SABR model is to be able to reproduce the smile effect of the volatility smile.

### GARCH model

The Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model is another popular model for estimating stochastic volatility. It assumes that the randomness of the variance process varies with the variance, as opposed to the square root of the variance as in the Heston model. The standard GARCH(1,1) model has the following form for the variance differential:

${\displaystyle d\nu _{t}=\theta (\omega -\nu _{t})\,dt+\xi \nu _{t}\,dB_{t}\,}$

The GARCH model has been extended via numerous variants, including the NGARCH, TGARCH, IGARCH, LGARCH, EGARCH, GJR-GARCH, etc. Strictly, however, the conditional volatilities from GARCH models are not stochastic since at time t the volatility is completely pre-determined (deterministic) given previous values.[3]

### 3/2 model

The 3/2 model is similar to the Heston model, but assumes that the randomness of the variance process varies with ${\displaystyle \nu _{t}^{3/2}}$. The form of the variance differential is:

${\displaystyle d\nu _{t}=\nu _{t}(\omega -\theta \nu _{t})\,dt+\xi \nu _{t}^{\frac {3}{2}}\,dB_{t}.\,}$

However the meaning of the parameters is different from Heston model. In this model both, mean reverting and volatility of variance parameters, are stochastic quantities given by ${\displaystyle \theta \nu _{t}}$ and ${\displaystyle \xi \nu _{t}}$ respectively.

### Chen model

In interest rate modelings, Lin Chen in 1994 developed the first stochastic mean and stochastic volatility model, Chen model. Specifically, the dynamics of the instantaneous interest rate are given by following the stochastic differential equations:

${\displaystyle dr_{t}=(\theta _{t}-\alpha _{t})\,dt+{\sqrt {r_{t}}}\,\sigma _{t},\,dW_{t},}$
${\displaystyle d\alpha _{t}=(\zeta _{t}-\alpha _{t})\,dt+{\sqrt {\alpha _{t}}}\,\sigma _{t}\,dW_{t},}$
${\displaystyle d\sigma _{t}=(\beta _{t}-\sigma _{t})\,dt+{\sqrt {\sigma _{t}}}\,\eta _{t}\,dW_{t}.}$

## Calibration

Once a particular SV model is chosen, it must be calibrated against existing market data. Calibration is the process of identifying the set of model parameters that are most likely given the observed data. One popular technique is to use maximum likelihood estimation (MLE). For instance, in the Heston model, the set of model parameters ${\displaystyle \Psi _{0}=\{\omega ,\theta ,\xi ,\rho \}\,}$ can be estimated applying an MLE algorithm such as the Powell Directed Set method [1] to observations of historic underlying security prices.

In this case, you start with an estimate for ${\displaystyle \Psi _{0}\,}$, compute the residual errors when applying the historic price data to the resulting model, and then adjust ${\displaystyle \Psi \,}$ to try to minimize these errors. Once the calibration has been performed, it is standard practice to re-calibrate the model periodically.