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A decomposition formula for option prices in the Heston model and applications to option pricing approximation

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Abstract

By 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.

Suggested Citation

  • Elisa Alòs, 2009. "A decomposition formula for option prices in the Heston model and applications to option pricing approximation," Economics Working Papers 1188, Department of Economics and Business, Universitat Pompeu Fabra.
    • Handle: RePEc:upf:upfgen:1188
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    More about this item

    Keywords

    Stochastic Volatility; Heston Model; Itô's Calculus.;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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