Pricing and hedging with rough Heston models

Omar El-Euch (Pierre and Marie Curie University - Paris 6)
Thursday, November 9, 2017 - 4:15pm
HU Berlin, Rudower Chaussee 25, Room 1.115

It has been recently shown that rough volatility models, where the volatility is driven by a fractional Brownian motion with small Hurst parameter, provide very relevant dynamics in order to reproduce the behavior of both historical and implied volatilities. However, due to the non-Markovian nature of the fractional Brownian motion, they raise new issues when it comes to derivatives pricing and hedging. Using an original link between nearly unstable Hawkes processes and fractional volatility models, we compute the characteristic function of the log-price in rough Heston models and obtain explicit hedging strategies. The replicating portfolios contain the underlying asset and the forward variance curve, and lead to perfect hedging (at least theoretically). From a probabilistic point of view, our study enables us to disentangle the infinite-dimensional Markovian structure associated to rough volatility models.