Tai-Ho Wang, Barach College, City University of New York

Target Volatility Option Pricing in Lognormal Fractional SABR Model

Abstract

We examine the pricing of target volatility options in the lognormal fractional SABR model.
A decomposition formula by Ito's calculus yields a theoretical replicating strategy for the target volatility option, assuming the accessibility of all variance swaps and swaptions. The same formula also suggests an approximation formula for the price of target volatility option in small time by the technique of freezing the coefficient.
Alternatively, we also derive closed formed expressions for a small volatility of volatility expansion of the price of target volatility option. Numerical experiments show accuracy of the approximations in a reasonably wide range of parameters.