A STOCHASTIC VOLATILITY MODEL FOR RISK-REVERSALS IN FOREIGN EXCHANGE

Abstract. It is a widely recognised fact that risk-reversals play a central role in the pricing of
derivatives in foreign exchange markets. It is also known that the values of risk-reversals vary
stochastically with time. In this paper we introduce a stochastic volatility model with jumps
and local volatility, defined on a continuous-time lattice, which provides a way of modelling
this kind of risk using numerically stable and relatively efficient algorithms.

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