Journal of Computational Finance

Risk.net

The forward smile in local–stochastic volatility models

Andrea Pascucci and Andrea Mazzon

  • Approximation for the forward implied volatility.
  • Local stochastic volatility models.
  • Explosion of the out-of-the-money forward smile.

ABSTRACT

We introduce an approximation of forward-start options in a multi-factor local-stochastic volatility model. We derive explicit expansion formulas for the so-called forward implied volatility, which can be useful to price complex path-dependent options as cliquets. The expansion involves only polynomials and can be computed without the need for numerical procedures or special functions. Recent results on the exploding behavior of the forward smile in the Heston model are confirmed and generalized to a wider class of local-stochastic volatility models. We illustrate the effectiveness of the technique through some numerical tests.

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