Modelling Equities with a Stochastic Volatility Jump Diffusion

Gorven, Matthew

Modelling Equities with a Stochastic Volatility Jump Diffusion

Master Thesis

2018

Publisher

University of Cape Town

Department

African Institute of Financial Markets and Risk Management

Faculty

Faculty of Commerce

Abstract

The Bates model provides a parsimonious fit to implied volatility surfaces, and its usefulness in developed markets is well documented. However, there is a lack of research assessing its applicability to developing markets. Additionally, research surrounding its usefulness for hedging long term liabilities is limited, despite its frequent use for this purpose. This dissertation dissects the dynamics of the Bates model into the Heston and Merton models in order to separately examine the effects of stochastic volatility and jumps. Challenges surrounding application of this model are investigated through an evaluation of risk-neutral calibration and simulation methods. The model’s ability to fit the implied volatility surfaces from the JSE Top 40 equity index is analysed. Lastly, an evaluation of the model’s delta and vega hedging performance is presented by comparing it to the hedge performance of other commonly used models.

Keywords

Mathematical Finance

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