A decomposition formula for option prices in the Heston model and applications to option pricing approximation
AbstractBy means of classical Itô's calculus we decompose option prices as the sum of the classical Black-Scholes formula with volatility parameter equal to the root-mean-square future average volatility plus a term due by correlation and a term due to the volatility of the volatility. This decomposition allows us to develop first and second-order approximation formulas for option prices and implied volatilities in the Heston volatility framework, as well as to study their accuracy. Numerical examples are given.
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Bibliographic InfoPaper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 1188.
Date of creation: Dec 2009
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Web page: http://www.econ.upf.edu/
Stochastic Volatility; Heston Model; Itô's Calculus.;
Find related papers by JEL classification:
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-12-19 (All new papers)
- NEP-CFN-2009-12-19 (Corporate Finance)
- NEP-ORE-2009-12-19 (Operations Research)
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