The Multivariate Mixture Dynamics Model: Shifted dynamics and correlation skew

TL;DR

This paper introduces a generalized multivariate mixture dynamics model with shifted dynamics, capable of accurately modeling and extrapolating implied volatility surfaces and correlations in FX markets, including illiquid currencies.

Contribution

It extends the MVMD model by incorporating shifted dynamics and defines implied correlation, enabling better modeling of FX cross rates and volatility smiles, especially for less liquid currencies.

Findings

The shifted MVMD model accurately reproduces the CNY/EUR smile.

It outperforms the shifted Simply Correlated Mixture Dynamics model in implied correlation estimation.

The model can be extended to include uncertain volatilities and correlations.

Abstract

The Multi Variate Mixture Dynamics model is a tractable, dynamical, arbitrage-free multivariate model characterized by transparency on the dependence structure, since closed form formulae for terminal correlations, average correlations and copula function are available. It also allows for complete decorrelation between assets and instantaneous variances. Each single asset is modelled according to a lognormal mixture dynamics model, and this univariate version is widely used in the industry due to its flexibility and accuracy. The same property holds for the multivariate process of all assets, whose density is a mixture of multivariate basic densities. This allows for consistency of single asset and index/portfolio smile. In this paper, we generalize the MVMD model by introducing shifted dynamics and we propose a definition of implied correlation under this model. We investigate whether the model is able to consistently reproduce the implied volatility of FX cross rates once the single components are calibrated to univariate shifted lognormal mixture dynamics models. We consider in particular the case of the Chinese renminbi FX rate, showing that the shifted MVMD model correctly recovers the CNY/EUR smile given the EUR/USD smile and the USD/CNY smile, thus highlighting that the model can also work as an arbitrage free volatility smile extrapolation tool for cross currencies that may not be liquid or fully observable. We compare the performance of the shifted MVMD model in terms of implied correlation with those of the shifted Simply Correlated Mixture Dynamics model where the dynamics of the single assets are connected naively by introducing correlation among their Brownian motions. Finally, we introduce a model with uncertain volatilities and correlation. The Markovian projection of this model is a generalization of the shifted MVMD model.