Abstract
We calibrate a novel multifactor stochastic volatility model that includes as special cases the Heston-based model of De Col et al. (J Bank Finance 37(10):3799–3818, 2013) and the 3/2-based model of Baldeaux et al. (J Bank Finance 53:34–48, 2015). Using a dataset on vanilla option quotes in a triangle of currencies, we find that the risk neutral approach typically fails for the calibrated model, in line with the results of Baldeaux et al. (2015).
Highlights
This paper aims to draw the attention to a more general modeling approach than available under the classical no-arbitrage paradigm in finance
We present and calibrate a hybrid model describing the dynamics of a vector of foreign exchange (FX) rates and the associated interest rates
We extend and unify the FX multifactor stochastic volatility models of De Col et al (2013) and Baldeaux et al (2015) by means of the general transform formula presented in Grasselli (2017)
Summary
This paper aims to draw the attention to a more general modeling approach than available under the classical no-arbitrage paradigm in finance. 3.3 that it naturally emerges, e.g., in a simple Heston setting for a suitable choice of the risk premium Such CIR factors can be freely combined in order to drive stochastic interest rates. Our multiple calibration experiment seems to suggest the presence of regime switches in traded FX-option prices between the standard risk neutral and the real-world pricing approach. Such a feature calls for a modeling framework which is able to span both valuation principles, which is provided by the benchmark approach.
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