The Heston model with stochastic elasticity of variance

Sun‐Yong Choi, Jeong‐Hoon Kim and Ji‐Hun Yoon

Applied Stochastic Models in Business and Industry, 2016, vol. 32, issue 6, 804-824

Abstract: Empirical evidence suggests that single factor models would not capture the full dynamics of stochastic volatility such that a marked discrepancy between their predicted prices and market prices exists for certain ranges (deep in‐the‐money and out‐of‐the‐money) of time‐to‐maturities of options. On the other hand, there is an empirical reason to believe that volatility skew fluctuates randomly. Based upon the idea of combining stochastic volatility and stochastic skew, this paper incorporates stochastic elasticity of variance running on a fast timescale into the Heston stochastic volatility model. This multiscale and multifactor hybrid model keeps analytic tractability of the Heston model as much as possible, while it enhances capturing the complex nature of volatility and skew dynamics. Asymptotic analysis based on ergodic theory yields a closed form analytic formula for the approximate price of European vanilla options. Subsequently, the effect of adding the stochastic elasticity factor on top of the Heston model is demonstrated in terms of implied volatility surface. Copyright © 2016 John Wiley & Sons, Ltd.

Date: 2016
References: Add references at CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
https://doi.org/10.1002/asmb.2203

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wly:apsmbi:v:32:y:2016:i:6:p:804-824

Access Statistics for this article

More articles in Applied Stochastic Models in Business and Industry from John Wiley & Sons
Bibliographic data for series maintained by Wiley Content Delivery ().