Efficient simulation of generalized SABR and stochastic local volatility models based on Markov chain approximations

Zhenyu Cui, J. Lars Kirkby, Duy Nguyen

Research output: Contribution to journalArticlepeer-review

30 Scopus citations

Abstract

We propose a novel Monte Carlo simulation method for two-dimensional stochastic differential equation (SDE) systems based on approximation through continuous-time Markov chains (CTMCs). Specifically, we propose an efficient simulation framework for asset prices under general stochastic local volatility (SLV) models arising in finance, which includes the Heston and the stochastic alpha beta rho (SABR) models as special cases. Our simulation algorithm is constructed based on approximating the latent stochastic variance process by a CTMC. Compared with time-discretization schemes, our method exhibits several advantages, including flexible boundary condition treatment, weak continuity conditions imposed on coefficients, and a second order convergence rate in the spatial grids of the approximating CTMC under suitable regularity conditions. Replacing the stochastic variance process with a discrete-state approximation greatly simplifies the direct sampling of the integrated variance, thus enabling a highly efficient simulation scheme. Extensive numerical examples illustrate the accuracy and efficiency of our estimator, which outperforms both biased and unbiased simulation estimators in the literature in terms of root mean squared error (RMSE) and computational time. This paper is focused primarily on the simulation of SDEs which arise in finance, but this new simulation approach has potential for applications in other contextual areas in operations research, such as queuing theory.

Original languageEnglish
Pages (from-to)1046-1062
Number of pages17
JournalEuropean Journal of Operational Research
Volume290
Issue number3
DOIs
StatePublished - 1 May 2021

Keywords

  • Finance
  • Markov chain
  • SABR
  • Simulation
  • Stochastic differential equation
  • Stochastic local volatility

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