Stochastic covariance and dimension reduction in the pricing of basket options

Marcos Escobar Anel (), Daniel Krause () and Rudi Zagst ()
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Daniel Krause: Technische Universität München
Rudi Zagst: Technische Universität München

Review of Derivatives Research, 2016, vol. 19, issue 3, No 1, 165-200

Abstract: Abstract This paper presents a tailor-made method for dimension reduction aimed at approximating the price of basket options in the context of stochastic volatility and stochastic correlation. The methodology is built on a modification to the Principal Component Stochastic Volatility (PCSV) model, a stochastic covariance model that accounts for most stylized facts in prices. The method to reduce dimension is first derived theoretically. Afterwards the results are applied to a multivariate lognormal context as a special case of the PCSV model. Finally empirical results for the application of the method to the general PCSV model are illustrated.

Keywords: Principal components; Basket options; Stochastic covariance (search for similar items in EconPapers)
JEL-codes: C61 C63 G13 (search for similar items in EconPapers)
Date: 2016
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DOI: 10.1007/s11147-016-9119-x

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