Approximate option pricing under a two-factor Heston–Kou stochastic volatility model

Youssef El-Khatib (), Zororo S. Makumbe () and Josep Vives ()
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Youssef El-Khatib: United Arab Emirates University
Zororo S. Makumbe: Universitat de Barcelona
Josep Vives: Universitat de Barcelona

Computational Management Science, 2024, vol. 21, issue 1, No 3, 28 pages

Abstract: Abstract Under a two-factor stochastic volatility jump (2FSVJ) model we obtain an exact decomposition formula for a plain vanilla option price and a second-order approximation of this formula, using Itô calculus techniques. The 2FSVJ model is a generalization of several models described in the literature such as Heston (Rev Financ Stud 6(2):327–343, 1993); Bates (Rev Financ Stud 9(1):69–107, 1996); Kou (Manag Sci 48(8):1086–1101, 2002); Christoffersen et al. (Manag Sci 55(12):1914–1932, 2009) models. Thus, the aim of this study is to extend some approximate pricing formulas described in the literature, like formulas in Alòs (Finance Stoch 16(3):403–422, 2012); Merino et al. (Int J Theor Appl Finance 21(08):1850052, 2018); Gulisashvili et al. (J Comput Finance 24(1), 2020), to pricing under the more general 2FSVJ model. Moreover, we provide numerical illustrations of our pricing method and its accuracy and computational advantage under double exponential and log-normal jumps. Numerically, our pricing method performs very well compared to the Fourier integral method. The performance is ideal for out-of-the-money options as well as for short maturities.

Keywords: Heston–Kou model; Stochastic volatility; Option price decomposition; Multi-factor models (search for similar items in EconPapers)
Date: 2024
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DOI: 10.1007/s10287-023-00486-8

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