Generalized sub-Riemannian cut loci and implied/local volatility smiles

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• Peter Friz (TU Berlin)
• Tuesday 24 April 2012, 16:30-17:30
• MR12, CMS, Wilberforce Road, Cambridge, CB3 0WB.

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Density expansions for hypoelliptic diffusions $(X^1,...,Xd)$ are revisited. In particular, we are interested in density expansions of the projection $(X_T^1,...,X_Tl)$, at fixed time $T>0$, with $l \leq d$. Global conditions are found which replace the well-known “not-in-cutlocus” condition known from heat-kernel asymptotics (Molchanov, Bismut, Ben Arous, ...). Our small noise expansion allows for a “second order” exponential factor, not present in small time expansions.

Applications include tail and implied/local volatility asymptotics in some correlated stochastic volatility models. In particular, we are able to analyze the Stein—Stein model in case of negative correlation (the typical case in equity markets), thereby solving a problem left open by A. Gulisashvili and E.M. Stein.

Joint work with Deuschel, Jacquier and Violante.

This talk is part of the Probability series.

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