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Valuation of power options under Heston's stochastic volatility model

Author

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  • Kim, Jerim
  • Kim, Bara
  • Moon, Kyoung-Sook
  • Wee, In-Suk

Abstract

We derive semi-analytic solutions for power option prices under the Heston model; specifically, the pricing formula is shown to be valid whenever the power of the underlying asset price has a finite moment. Unlike the majority of stochastic volatility models, there remains a significant problem to check the existence of moments of assets prices of order higher than one. Fortunately, the moment explosion property under the Heston model is examined systematically in Andersen and Piterbarg (2000). Incorporating with their results, we present explicit formulas for moment generating function of log price and for power option prices under the circumstances when the corresponding moments are finite. In case that the corresponding moment explodes, we provide two numerical methods to derive prices of power put and capped power call options. In spite of a simple idea, numerical examples show that the approximations are extremely accurate and efficient.

Suggested Citation

  • Kim, Jerim & Kim, Bara & Moon, Kyoung-Sook & Wee, In-Suk, 2012. "Valuation of power options under Heston's stochastic volatility model," Journal of Economic Dynamics and Control, Elsevier, vol. 36(11), pages 1796-1813.
    • Handle: RePEc:eee:dyncon:v:36:y:2012:i:11:p:1796-1813
    DOI: 10.1016/j.jedc.2012.05.005
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    Cited by:

    1. Zhang, Wei-Guo & Li, Zhe & Liu, Yong-Jun, 2018. "Analytical pricing of geometric Asian power options on an underlying driven by a mixed fractional Brownian motion," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 490(C), pages 402-418.
    2. E. Ngounda & K. C. Patidar & E. Pindza, 2014. "A Robust Spectral Method for Solving Heston’s Model," Journal of Optimization Theory and Applications, Springer, vol. 161(1), pages 164-178, April.
    3. Legendre, François & Togola, Djibril, 2016. "Explicit solutions to dynamic portfolio choice problems: A continuous-time detour," Economic Modelling, Elsevier, vol. 58(C), pages 627-641.
    4. Elham Dastranj & Roghaye Latifi, 2017. "A comparison of option pricing models," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 4(02n03), pages 1-11, June.
    5. Zhang, Zhiqiang & Liu, Weiqi & Sheng, Yuhong, 2016. "Valuation of power option for uncertain financial market," Applied Mathematics and Computation, Elsevier, vol. 286(C), pages 257-264.

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    More about this item

    Keywords

    Power option; Stochastic volatility; Heston model; Change of numeraire; Fourier transform;
    All these keywords.

    JEL classification:

    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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