The 3/2 Model As A Stochastic Volatility Approximation For A Large-Basket Price-Weighted Index
2015 (English)In: International Journal of Theoretical and Applied Finance, ISSN 0219-0249, Vol. 18, no 6, 1550041Article in journal (Refereed) PublishedText
We derive large-basket approximations of a price-weighted index whose component prices follow a single sector jump-diffusion model. As the basket size approaches infinity, a suitable average converges to a Black-Scholes model driven by the common factor process. We extend this by considering the behavior of the residual idiosyncratic noise and show that a version of the 3/2 model emerges as a natural stochastic volatility model approximation. This provides a theoretical justification for its use as a model for jointly pricing index and volatility derivatives.
Place, publisher, year, edition, pages
2015. Vol. 18, no 6, 1550041
Index models, stochastic volatility models, large portfolio limit, diffusion approximation, volatility derivatives
IdentifiersURN: urn:nbn:se:uu:diva-271056DOI: 10.1142/S0219024915500417ISI: 000365773200006OAI: oai:DiVA.org:uu-271056DiVA: diva2:891078