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Stochastic Volatility and Forward-Start Option Skew

Article Quant Q&A · Author: BS.
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Summary

The document asks why stochastic volatility may be more suitable than local volatility for pricing a forward-start option, whose strike is set at a future date. Its brief answer points to the shape of the future implied-volatility skew: local-volatility models are said to produce a skew that is too shallow, which can lead to errors in derivatives whose values depend on that forward skew.

The response offers a qualitative modeling rationale, but it is fragmentary. It gives no derivation, model specification, numerical comparison, or empirical evidence, and it only alludes to a supporting paper without explaining its findings. The claim should therefore be treated as a prompt for further study rather than a general result established by the document. It highlights the need to assess a volatility model against the forward distribution features relevant to the contract being priced.

Key ideas

  • Forward-start options have strikes determined at a future date.
  • The response claims local-volatility models can produce an overly shallow forward skew.
  • Contracts sensitive to forward skew may be mispriced when that feature is modeled poorly.
  • The document gives no derivation or evidence, so its model comparison remains unsubstantiated here.

Tags

OptionsVolatilityDerivatives pricing
Full text
# Stochastic volatility and forward start contracts


# Stochastic volatility and forward start contracts












Why is it more accurate to use stochastic volatility when pricing let's say a forward start option (ie an option priced today but striked in a future date) ?

## Answer by mbison (score 1)

https://quant.stackexchange.com/a/25879

Local vol model gives a "too shallow" forward skew. Derivatives of which the price are depending on the forward skew will be mispriced. If i remember correctly, Hagan's paper

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.