Simple approximations for option pricing under mean reversion and stochastic volatility (Q1424642)

The author considers two basic market models: (1) a geometric Brownian motion (GBM) commonly used in financial markets models, and (2) mean-reverting (MR) processes used for the description of commodity markets. Problems of stochastic volatility are discussed. Discrete time approximations (AR(1), random walk with drift and GARCH(1,1)) are considered. Simple approximated formulas for option pricing are given for these models. This technique is applied to the pricing of European options on the spot price of electricity in the Scandinavian market NordPool.