Option pricing under Ornstein-Uhlenbeck stochastic volatility: a linear model
We consider the problem of option pricing under stochastic volatility models, focusing on the linear approximation of the two processes known as exponential Ornstein-Uhlenbeck and Stein-Stein. Indeed, we show they admit the same limit dynamics in the regime of low fluctuations of the volatility process, under which we derive the exact expression of the characteristic function associated to the risk neutral probability density. This expression allows us to compute option prices exploiting a formula derived by Lewis and Lipton. We analyze in detail the case of Plain Vanilla calls, being liquid instruments for which reliable implied volatility surfaces are available. We also compute the analytical expressions of the first four cumulants, that are crucial to implement a simple two steps calibration procedure. It has been tested against a data set of options traded on the Milan Stock Exchange. The data analysis that we present reveals a good fit with the market implied surfaces and corroborates the accuracy of the linear approximation.
|Date of creation:||May 2009|
|Date of revision:||May 2010|
|Publication status:||Published in Int. J. Theoretical Appl. Finance 7 (2010) 1047-1063|
|Contact details of provider:|| Web page: http://arxiv.org/|
References listed on IDEAS
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- Miccichè, Salvatore & Bonanno, Giovanni & Lillo, Fabrizio & Mantegna, Rosario N, 2002.
"Volatility in financial markets: stochastic models and empirical results,"
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- Stefano Galluccio & Yann Le Cam, 2005. "Implied Calibration of Stochastic Volatility Jump Diffusion Models," Finance 0510028, EconWPA. Full references (including those not matched with items on IDEAS)
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