A fast mean-reverting correction to Heston's stochastic volatility model

DOI10.1137/090761458zbMATH Open1217.91189arXiv1007.4366OpenAlexW2004330626MaRDI QIDQ2996524FDOQ2996524

Authors: Jean-Pierre Fouque, Matthew Lorig 

Publication date: 2 May 2011

Published in: SIAM Journal on Financial Mathematics (Search for Journal in Brave)

Abstract: We propose a multi-scale stochastic volatility model in which a fast mean-reverting factor of volatility is built on top of the Heston stochastic volatility model. A singular pertubative expansion is then used to obtain an approximation for European option prices. The resulting pricing formulas are semi-analytic, in the sense that they can be expressed as integrals. Difficulties associated with the numerical evaluation of these integrals are discussed, and techniques for avoiding these difficulties are provided. Overall, it is shown that computational complexity for our model is comparable to the case of a pure Heston model, but our correction brings significant flexibility in terms of fitting to the implied volatility surface. This is illustrated numerically and with option data.

Full work available at URL: https://arxiv.org/abs/1007.4366

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zbMATH Keywords

asymptoticsstochastic volatilityHeston modelimplied volatility smile/skewfast mean reversion

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20) Interest rates, asset pricing, etc. (stochastic models) (91G30)

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