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Moment explosions in stochastic volatility models

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Abstract

In this paper, we demonstrate that many stochastic volatility models have the undesirable property that moments of order higher than 1 can become infinite in finite time. As arbitrage-free price computation for a number of important fixed income products involves forming expectations of functions with super-linear growth, such lack of moment stability is of significant practical importance. For instance, we demonstrate that reasonably parametrized models can produce infinite prices for Eurodollar futures and for swaps with floating legs paying either Libor-in-arrears or a constant maturity swap rate. We systematically examine the moment explosion property across a spectrum of stochastic volatility models. We show that lognormal and displaced-diffusion type models are easily prone to moment explosions, whereas CEV-type models (including the so-called SABR model) are not. Related properties such as the failure of the martingale property are also considered.

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Authors and Affiliations

  1. Bank of America, 630 Fifth Avenue, New York, NY, 10111, USA

    Leif B. G. Andersen

  2. Barclays Capital, The North Colonnade, Canary Wharf, London, E14 4BB, UK

    Vladimir V. Piterbarg

Authors
  1. Leif B. G. Andersen
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  2. Vladimir V. Piterbarg
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Correspondence to Vladimir V. Piterbarg.

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Andersen, L.B.G., Piterbarg, V.V. Moment explosions in stochastic volatility models. Finance Stoch 11, 29–50 (2007). https://doi.org/10.1007/s00780-006-0011-7

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  • DOI: https://doi.org/10.1007/s00780-006-0011-7

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