hard · Quantitative Finance derivatives

In a stochastic-volatility model (e.g. Heston), a long-dated cliquet pays the sum of capped monthly returns. A risk manager observes that, holding the market vanilla surface fixed, switching from a local-volatility model to a pure stochastic-volatility model materially changes the cliquet price even though both are calibrated to the same vanillas.

What is the primary financial reason for this model dependence?

  1. Local and stochastic volatility imply different forward-smile dynamics, and the cliquet's value depends on the forward smile, which vanillas do not pin down
  2. Local volatility produces arbitrage in the vanilla surface that stochastic volatility removes, so the price gap reflects an arbitrage adjustment to the cliquet
  3. The two models assign different prices to the underlying forwards, so the discrepancy is a difference in the calibrated drift rather than in volatility dynamics
  4. Stochastic volatility violates put–call parity for the monthly options embedded in the cliquet, inflating the capped-return legs relative to local volatility

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