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A hybrid approach for the implementation of the Heston model

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  • Maya Briani
  • Lucia Caramellino
  • Antonino Zanette

Abstract

We propose a hybrid tree-finite difference method in order to approximate the Heston model. We prove the convergence by embedding the procedure in a bivariate Markov chain and we study the convergence of European and American option prices. We finally provide numerical experiments that give accurate option prices in the Heston model, showing the reliability and the efficiency of the algorithm.

Suggested Citation

  • Maya Briani & Lucia Caramellino & Antonino Zanette, 2013. "A hybrid approach for the implementation of the Heston model," Papers 1307.7178, arXiv.org, revised Sep 2017.
    • Handle: RePEc:arx:papers:1307.7178
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    References listed on IDEAS

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    1. John C. Cox & Jonathan E. Ingersoll Jr. & Stephen A. Ross, 2005. "A Theory Of The Term Structure Of Interest Rates," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 5, pages 129-164, World Scientific Publishing Co. Pte. Ltd..
    2. Nigel Clarke & Kevin Parrott, 1999. "Multigrid for American option pricing with stochastic volatility," Applied Mathematical Finance, Taylor & Francis Journals, vol. 6(3), pages 177-195.
    3. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," University of California at Los Angeles, Anderson Graduate School of Management qt43n1k4jb, Anderson Graduate School of Management, UCLA.
    4. Longstaff, Francis A & Schwartz, Eduardo S, 2001. "Valuing American Options by Simulation: A Simple Least-Squares Approach," The Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 113-147.
    5. Elisa Appolloni & Lucia Caramellino & Antonino Zanette, 2013. "A robust tree method for pricing American options with CIR stochastic interest rate," Papers 1305.0479, arXiv.org.
    6. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," The Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
    7. Brennan, Michael J. & Schwartz, Eduardo S., 1976. "The pricing of equity-linked life insurance policies with an asset value guarantee," Journal of Financial Economics, Elsevier, vol. 3(3), pages 195-213, June.
    8. Carl Chiarella & Boda Kang & Gunter H. Meyer, 2010. "The Evaluation Of Barrier Option Prices Under Stochastic Volatility," Research Paper Series 266, Quantitative Finance Research Centre, University of Technology, Sydney.
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    Cited by:

    1. Ludovic Gouden`ege & Andrea Molent & Antonino Zanette, 2023. "Backward Hedging for American Options with Transaction Costs," Papers 2305.06805, arXiv.org, revised Jun 2023.
    2. Ludovic Gouden`ege & Andrea Molent & Antonino Zanette, 2018. "Computing Credit Valuation Adjustment solving coupled PIDEs in the Bates model," Papers 1809.05328, arXiv.org.
    3. Ludovic Goudenege & Andrea Molent & Antonino Zanette, 2019. "Pricing and hedging GMWB in the Heston and in the Black–Scholes with stochastic interest rate models," Computational Management Science, Springer, vol. 16(1), pages 217-248, February.
    4. Ludovic Goudenège & Andrea Molent & Antonino Zanette, 2020. "Computing credit valuation adjustment solving coupled PIDEs in the Bates model," Computational Management Science, Springer, vol. 17(2), pages 163-178, June.
    5. Ludovic Goudenege & Andrea Molent & Antonino Zanette, 2015. "Pricing and Hedging GLWB in the Heston and in the Black-Scholes with Stochastic Interest Rate Models," Papers 1509.02686, arXiv.org.
    6. Ludovic Gouden`ege & Andrea Molent & Antonino Zanette, 2019. "Gaussian Process Regression for Pricing Variable Annuities with Stochastic Volatility and Interest Rate," Papers 1903.00369, arXiv.org, revised Jul 2019.
    7. Bertram During & Alexander Pitkin, 2017. "High-order compact finite difference scheme for option pricing in stochastic volatility jump models," Papers 1704.05308, arXiv.org, revised Feb 2019.

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