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A Parsimonious Multi-Asset Heston Model: Calibration And Derivative Pricing

  • GEORGI DIMITROFF

    ()

    (DZ Bank AG, Platz der Republik, 60265 Frankfurt am Main, Germany)

  • STEFAN LORENZ

    ()

    (Fraunhofer ITWM, Fraunhofer-Platz 1, 67663 Kaiserslautern, Germany)

  • ALEXANDER SZIMAYER

    ()

    (Department of Business Administration, University of Hamburg, Von-Melle-Park 5, 20146 Hamburg, Germany)

Registered author(s):

    We propose a parsimonious multi-asset Heston model and provide an easy-to-implement calibration algorithm. The model is customized to pricing multi-asset options in markets with liquidly traded single-asset options but no liquidly traded cross-asset options. In this situation, single-asset model parameters can be calibrated from option price data, however, cross-asset parameters cannot. We formulate a parsimonious model specification such that all single-asset models are Heston models, which are affine allowing for efficient calibration of the respective parameters. The single-asset models are correlated using cross-asset correlations only. Cross-asset correlations are observable, in contrast to correlations of latent variables such as volatilities, and serve as basis for calibration. A hybrid calibration approach for identifying the model parameters consistent with option price data and asset price data is outlined and illustrated by a case study. In banking practice the approach is referred to as correlation adjustment.

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    Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.

    Volume (Year): 14 (2011)
    Issue (Month): 08 ()
    Pages: 1299-1333

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    Handle: RePEc:wsi:ijtafx:v:14:y:2011:i:08:p:1299-1333
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