Hartman-Watson and Stochastic Volatility

Consider SABR with beta = 1 case:

T

F (T ) = exp
0

(t)dW (t)

1 2

T 0

2 (t)dt

where d(t) = (t)dZ(t) , and d[W, Z]t = dt. In particular, W (t) = Z(t) + Z (t), where = (1 2 )1/2 and Z is independent of Z. Note that
T T T

(t)dW (t) =
0 0

(t)dZ(t) +
0 0

(t)dZ (t)
T

((T ) (0)) +

(t)dZ (t)

Therefore, given a path of , the distribution of F (T ) is a log-normal, which is equivalent to 1 exp U 2 , 2 where U is a standard normal random variable,
T

=
0

2 (t)dt

1/2

T 1 ((T ) (0)) 2 2 (t)dt . 2 0 From Fubinis theorem on a product space of two Brownian motions Z and Z , a discount-free call option price on F (T ) is:

and

= exp

E N

log(/K) 1 log(/K) 1 + KN 2 2 1

This can be integrated numerically (2 dimensional Gauss quadrature, for example) once we have the joint distribution of Z(T ) and
T 0

2 (t)dt =
0

2 (0) exp 2Z(t) 2 t dt .

The joint distribution is known as the Hartman-Watson distribution.