N°22-71: Pricing Autocallables under Local-Stochastic Volatility

This paper investigates the pricing of single-asset autocallable barrier reverse convertibles in the Heston local-stochastic volatility (LSV) model. Despite their complexity, autocallable structured notes are the most traded equity-linked exotic derivatives. The autocallable payoff embeds an early-redemption feature generating strong path- and model-dependency. Consequently, the commonly-used local volatility (LV) model is overly simplified for pricing and risk management. Given its ability to match the implied volatility smile and reproduce its realistic dynamics, the LSV model is, in contrast, better suited for exotic derivatives such as autocallables. We use quasi-Monte Carlo methods to study the pricing given the Heston LSV model and compare it with the LV model. In particular, we establish the sensitivity of the valuation differences of autocallables between the two models with respect to payoff features, model parameters, underlying characteristics, and volatility regimes. We find that the improved spot-volatility dynamics captured by the Heston LSV model typically result in higher prices, demonstrating the dependence of autocallables on the forward-skew. Moreover, we show that the parameters of the stochastic component of LSV models enable controlling for the autocallables price while leaving the fit to European options unaffected.