Pricing Options with Vanishing Stochastic Volatility

Abstract

In the past years, there has been an extensive investigation of the class of stochastic volatility models for the evaluation of options and complex derivatives. These models have proven to be extremely useful in generalizing the classic Black–Scholes economy and accounting for discrepancies between observation and predictions in the simple log-normal, constant-volatility model. In this paper, we study the structure of an options market with a stochastic volatility that will eventually vanish (i.e., reaches zero) for very short periods of time with probability of one. We investigate the form of pricing measures in this situation, first in a simple binomial case, and then for a diffusion model, by constructing a weak approximation in discrete space and continuous time. The market described allows fleeting arbitrage opportunities, since a vanishing volatility prevents the construction of an equivalent measure, so that pricing contingent claims are, a priori, not obvious. Nevertheless, we can still produce a fair pricing equation. Let us note that this issue is not only of theoretical relevance, as the phenomenon of very low volatility has indeed been observed in the financial markets and the economy for quite a long time in the recent past.