Black–Scholes in a CEV random environment

Abstract

Classical (Ito diffusions) stochastic volatility models are not able to capture the steepness of small-maturity implied volatility smiles. Jumps, in particular exponential Levy and affine models, which exhibit small-maturity exploding smiles, have historically been proposed to remedy this (see Tankov in Pricing and hedging in exponential Levy models: review of recent results. Paris-Princeton Lecture Notes in Mathematical Finance, Springer, Berlin, 2010 for an overview), and more recently rough volatility models (Alos et al. in On the short-time behavior of the implied volatility for jump-diffusion models with stochastic volatility. Finance Stoch 11(4):571–589, 2007, Fukasawa in Asymptotic analysis for stochastic volatility: martingale expansion. Finance Stoch 15:635–654, 2011). We suggest here a different route, randomising the Black–Scholes variance by a CEV-generated distribution, which allows us to modulate the rate of explosion (through the CEV exponent) of the implied volatility for small maturities. The range of rates includes behaviours similar to exponential Levy models and fractional stochastic volatility models.