Extreme-Strike Asymptotics for General Gaussian Stochastic Volatility Models (1502.05442v3)

Abstract: We consider a stochastic volatility asset price model in which the volatility is the absolute value of a continuous Gaussian process with arbitrary prescribed mean and covariance. By exhibiting a Karhunen-Lo`{e}ve expansion for the integrated variance, and using sharp estimates of the density of a general second-chaos variable, we derive asymptotics for the asset price density for large or small values of the variable, and study the wing behavior of the implied volatility in these models. Our main result provides explicit expressions for the first five terms in the expansion of the implied volatility. The expressions for the leading three terms are simple, and based on three basic spectral-type statistics of the Gaussian process: the top eigenvalue of its covariance operator, the multiplicity of this eigenvalue, and the $L^{2}$ norm of the projection of the mean function on the top eigenspace. The fourth term requires knowledge of all eigen-elements. We present detailed numerics based on realistic liquidity assumptions in which classical and long-memory volatility models are calibrated based on our expansion.