| Abstract: | Under the SABR stochastic volatility model, pricing and hedging contracts that are sensitive to forward smile risk (e.g., forward starting options, barrier options) require the joint transition density. In this paper, we address this problem by providing closed‐form representations, asymptotically, of the joint transition density. Specifically, we construct an expansion of the joint density through a hierarchy of parabolic equations after applying total volatility‐of‐volatility scaling and a near‐Gaussian coordinate transformation. We then establish an existence result to characterize the truncation error and provide explicit joint density formulas for the first three orders. Our approach inherits the same spirit of a small total volatility‐of‐volatility assumption as in the original SABR analysis. Our results for the joint transition density serve as a basis for managing forward smile risk. Through numerical experiments, we illustrate the accuracy of our expansion in terms of joint density, marginal density, probability mass, and implied volatilities for European call options. |
