Affine fractional stochastic volatility models

Abstract

By fractional integration of a square root volatility process, we propose in this paper a long memory extension of the Heston (Rev Financ Stud 6:327–343, 1993) option pricing model. Long memory in the volatility process allows us to explain some option pricing puzzles as steep volatility smiles in long term options and co-movements between implied and realized volatility. Moreover, we take advantage of the analytical tractability of affine diffusion models to clearly disentangle long term components and short term variations in the term structure of volatility smiles. In addition, we provide a recursive algorithm of discretization of fractional integrals in order to be able to implement a method of moments based estimation procedure from the high frequency observation of realized volatilities.