Target volatility option pricing in lognormal fractional SABR model

TL;DR

This paper develops theoretical and approximation formulas for pricing target volatility options within the lognormal fractional SABR model, supported by numerical experiments demonstrating their accuracy across various parameters.

Contribution

It introduces new decomposition and approximation formulas for target volatility option pricing in the fractional SABR model, including small-time and small-volatility-of-volatility expansions.

Findings

Approximation formulas are accurate over a wide parameter range.

Theoretical replicating strategy derived assuming access to variance swaps and swaptions.

Closed-form expressions for small volatility of volatility expansion.

Abstract

We examine in this article 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 accessibilities 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.