Simple approximations for option pricing under mean reversion and stochastic volatility

Christian Hafner

No EI 2003-20, Econometric Institute Research Papers from Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute

Abstract: This paper provides simple approximations for evaluating option prices and implied volatilities under stochastic volatility. Simple recursive formulae are derived that can easily be implemented in spreadsheets. The traditional random walk assumption, dominating in the analysis of financial markets, is compared with mean reversion which is often more relevant in commodity markets. Deterministic components in the mean and volatility are taken into consideration to allow for seasonality, another frequent aspect of commodity markets. The stochastic volatility is suitably modelled by GARCH. An application to electricity options shows that the choice between a random walk and a mean reversion model can have strong effects for predictions of implied volatilities even if the two models are statistically close to each other.

Keywords: derivatives; energy markets; mean reversion; seasonality; spreadsheets; stochastic volatility (search for similar items in EconPapers)
JEL-codes: C14 C22 (search for similar items in EconPapers)
Date: 2003-07-08
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Citations: View citations in EconPapers (1)

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