THE HESTON STOCHASTIC-LOCAL VOLATILITY MODEL: EFFICIENT MONTE CARLO SIMULATION

Anthonie W. van der Stoep (), Lech Grzelak and Cornelis Oosterlee
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Anthonie W. van der Stoep: Derivatives Research and Validation Group, Rabobank, Graadt van Roggenweg 400, 3531 AH, Utrecht, The Netherlands;

International Journal of Theoretical and Applied Finance (IJTAF), 2014, vol. 17, issue 07, 1-30

Abstract: In this paper we propose an efficient Monte Carlo scheme for simulating the stochastic volatility model of Heston (1993) enhanced by a nonparametric local volatility component. This hybrid model combines the main advantages of the Heston model and the local volatility model introduced by Dupire (1994) and Derman & Kani (1998). In particular, the additional local volatility component acts as a "compensator" that bridges the mismatch between the nonperfectly calibrated Heston model and the market quotes for European-type options. By means of numerical experiments we show that our scheme enables a consistent and fast pricing of products that are sensitive to the forward volatility skew. Detailed error analysis is also provided.

Keywords: Heston stochastic-local volatility; HSLV; stochastic volatility; local volatility; Heston; hybrid models; calibration; Monte Carlo (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (20)

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DOI: 10.1142/S0219024914500459

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