Local Stochastic Correlation Models for Derivative Pricing

This paper reveals a simple methodology to create local-correlation models suitable for the closed-form pricing of two-asset financial derivatives. The multivariate models are built to ensure two conditions. First, marginals follow desirable processes, e.g., we choose the Geometric Brownian Motion (GBM), popular for stock prices. Second, the payoff of the derivative should follow a desired one-dimensional process. These conditions lead to a specific choice of the dependence structure in the form of a local-correlation model. Two popular multi-asset options are entertained: a spread option and a basket option.