Financial Modeling in a Fast Mean-Reverting Stochastic Volatility Environment

We present a derivative pricing and estimation methodology for a class of stochastic volatility models that exploits the observed "bursty" or persistent nature of stock price volatility. Empirical analysis of high-frequency S&P 500 index data confirms that volatility reverts slowly to its mean in comparison to the tick-by-tick fluctuations of the index value, but it is fast mean-reverting when looked at over the time scale of a derivative contract (many months). This motivates an asymptotic analysis of the partial differential equation satisfied by derivative prices, utilizing the distinction between these time scales. The analysis yields pricing and implied volatility formulas, and the latter provides a simple procedure to "fit the skew" from European index option prices. The theory identifies the important group parameters that are needed for the derivative pricing and hedging problem for European-style securities, namely the average volatility and the slope and intercept of the impl..