Calibration of a hybrid local-stochastic volatility stochastic rates model with a control variate particle method

Journal article

We propose a novel and generic calibration technique for four-factor foreign-exchange hybrid local-stochastic volatility models (LSV) with stochastic short rates. We build upon the particle method introduced by Guyon and Henry-Labord`ere [Nonlinear Option Pricing, Chapter 11, Chapman and Hall, 2013] and combine it with new variance reduction techniques in order to accelerate convergence. We use control variates derived from: a calibrated pure local volatility model, a two-factor Heston-type LSV model (both with deterministic rates), and the stochastic (CIR) short rates. The method can be applied to a large class of hybrid LSV models and is not restricted to our particular choice of the diffusion. However, we address in the paper some specific difficulties arising from the Heston model, notably by a new PDE formulation and finite element solution to bypass the singularities of the density when zero is attainable by the variance. The calibration procedure is performed on market data for the EUR-USD currency pair and has a comparable run-time to the PDE calibration of a two-factor LSV model alone.

Authors: Cozma, A; Mariapragassam, M; Reisinger, C

• Publication status: Published
• Peer review status: Peer reviewed
• Publisher: Society for Industrial and Applied Mathematics
• Journal: SIAM Journal on Financial Mathematics
• Volume: 10
• Issue: 1
• Pages: 181–213
• Publication date: 2019-03-07
• Acceptance date: 2018-12-08
• DOI: 10.1137/17M1114570
• ISSN: 1945-497X
• Keywords: calibration; Heston-type local-stochastic volatility models; particle method; Fokker Planck equation; control variate