A decomposition formula for option prices in the Heston model and applications to option pricing approximation

Elisa Alòs ()
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Elisa Alòs: https://www.upf.edu/web/econ/faculty/-/asset_publisher/6aWmmXf28uXT/persona/id/3418685

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

Abstract: By means of classical Itô's calculus we decompose option prices as the sum of the classical Black-Scholes formula with volatility parameter equal to the root-mean-square future average volatility plus a term due by correlation and a term due to the volatility of the volatility. This decomposition allows us to develop first and second-order approximation formulas for option prices and implied volatilities in the Heston volatility framework, as well as to study their accuracy. Numerical examples are given.

Keywords: Stochastic Volatility; Heston Model; Itô's Calculus. (search for similar items in EconPapers)
JEL-codes: G13 (search for similar items in EconPapers)
Date: 2009-12
New Economics Papers: this item is included in nep-cfn and nep-ore
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