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Nephalem
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Posts: 8
Joined: September 20th, 2016, 12:01 pm

Stochastic vol

July 17th, 2017, 1:32 pm

Dear forum,

Sometimes for pricing derivatives we use deterministic vol (e.g. Local Vol) and sometimes stochastic vol (e.g. Heston). For which products stochastic vol is much more preferable? 
 
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frolloos
Posts: 1416
Joined: September 27th, 2007, 5:29 pm
Location: Netherlands

Re: Stochastic vol

July 17th, 2017, 1:52 pm

Local vol and stoch vol give different smile dynamics. Depending on how sensitive the product that you are pricing / hedging is to future smile dynamics you choose for local or stoch vol. Better yet, combine the two models so that 1. ) your vanilla prices match market prices for all tenors and strikes (the local vol component), and 2.) you have more realistic smile dynamics (the stoch vol component).
 
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Nephalem
Topic Author
Posts: 8
Joined: September 20th, 2016, 12:01 pm

Re: Stochastic vol

July 18th, 2017, 9:50 am

frolloos wrote:
Local vol and stoch vol give different smile dynamics. Depending on how sensitive the product that you are pricing / hedging is to future smile dynamics you choose for local or stoch vol. Better yet, combine the two models so that 1. ) your vanilla prices match market prices for all tenors and strikes (the local vol component), and 2.) you have more realistic smile dynamics (the stoch vol component).

Thanks!
 
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gatarek
Posts: 290
Joined: July 14th, 2002, 3:00 am

Re: Stochastic vol

July 18th, 2017, 10:42 am

Stochastic local vol is the benchmark these day, all major houses use it.
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