The SABR Model: Explicit Formulae of the Moments of the Forward Prices/Rates Variable and Series Expansions of the Transition Probability Density and of the Option Prices

Lorella  Fatone; Francesca  Mariani; Maria Cristina  Recchioni; Francesco  Zirilli

doi:10.4236/jamp.2014.27062

JAMP Vol.2 No.7 , June 2014

The SABR Model: Explicit Formulae of the Moments of the Forward Prices/Rates Variable and Series Expansions of the Transition Probability Density and of the Option Prices

Lorella Fatone^*, Francesca Mariani, Maria Cristina Recchioni, Francesco Zirilli^*

Abstract: The SABR stochastic volatility model with β-volatility β ? (0,1) and an absorbing barrier in zero imposed to the forward prices/rates stochastic process is studied. The presence of (possibly) nonzero correlation between the stochastic differentials that appear on the right hand side of the model equations is considered. A series expansion of the transition probability density function of the model in powers of the correlation coefficient of these stochastic differentials is presented. Explicit formulae for the first three terms of this expansion are derived. These formulae are integrals of known integrands. The zero-th order term of the expansion is a new integral formula containing only elementary functions of the transition probability density function of the SABR model when the correlation coefficient is zero. The expansion is deduced from the final value problem for the backward Kolmogorov equation satisfied by the transition probability density function. Each term of the expansion is defined as the solution of a final value problem for a partial differential equation. The integral formulae that give the solutions of these final value problems are based on the Hankel and on the Kontorovich-Lebedev transforms. From the series expansion of the probability density function we deduce the corresponding expansions of the European call and put option prices. Moreover we deduce closed form formulae for the moments of the forward prices/rates variable. The moment formulae obtained do not involve integrals or series expansions and are expressed using only elementary functions. The option pricing formulae are used to study synthetic and real data. In particular we study a time series (of real data) of futures prices of the EUR/USD currency's exchange rate and of the corresponding option prices. The website: http://www.econ.univpm.it/recchioni/finance/w18 contains material including animations, an interactive application and an app that helps the understanding of the paper. A more general reference to the work of the authors and of their coauthors in mathematical finance is the website: http://www.econ.univpm.it/recchioni/finance.

Keywords: SABR Stochastic Volatility Models, Option Pricing, Spectral Decomposition, FX Data

Cite this paper: Fatone, L. , Mariani, F. , Recchioni, M. and Zirilli, F. (2014) The SABR Model: Explicit Formulae of the Moments of the Forward Prices/Rates Variable and Series Expansions of the Transition Probability Density and of the Option Prices. Journal of Applied Mathematics and Physics, 2, 540-568. doi: 10.4236/jamp.2014.27062.

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