A Market Driver Volatility Model via Policy Improvement Algorithm

TL;DR

This paper introduces a modified Heston model incorporating market driver impact to better capture nonlinear volatility effects caused by trader concentration, aiding in more accurate derivative valuation and risk management.

Contribution

It develops a revised Heston PDE that accounts for market impact via a market driver, enhancing valuation accuracy in OTC derivatives markets.

Findings

Revised PDE captures market impact effects.

Model improves derivative valuation accuracy.

Helps traders hedge against market impact risks.

Abstract

In the over-the-counter market in derivatives, we sometimes see large numbers of traders taking the same position and risk. When there is this kind of concentration in the market, the position impacts the pricings of all other derivatives and changes the behaviour of the underlying volatility in a nonlinear way. We model this effect using Heston's stochastic volatility model modified to take into account the impact. The impact can be incorporated into the model using a special product called a market driver, potentially with a large face value, affecting the underlying volatility itself. We derive a revised version of Heston's partial differential equation which is to be satisfied by arbitrary derivatives products in the market. This enables us to obtain valuations that reflect the actual market and helps traders identify the risks and hold appropriate assets to correctly hedge against the impact of the market driver.