Closed-form approximations with respect to the mixing solution for option pricing under stochastic volatility
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Publication:5094574
Time series, auto-correlation, regression, etc. in statistics (GARCH) (62M10) Derivative securities (option pricing, hedging, etc.) (91G20) Numerical methods (including Monte Carlo methods) (91G60) Stochastic ordinary differential equations (aspects of stochastic analysis) (60H10) Stochastic models in economics (91B70)
Abstract: We consider closed-form approximations for European put option prices within the Heston and GARCH diffusion stochastic volatility models with time-dependent parameters. Our methodology involves writing the put option price as an expectation of a Black-Scholes formula and performing a second-order Taylor expansion around the mean of its argument. The difficulties then faced are simplifying a number of expectations induced by the Taylor expansion. Under the assumption of piecewise-constant parameters, we derive closed-form pricing formulas and devise a fast calibration scheme. Furthermore, we perform a numerical error and sensitivity analysis to investigate the quality of our approximation and show that the errors are well within the acceptable range for application purposes. Lastly, we derive bounds on the remainder term generated by the Taylor expansion.
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Cited in
(6)- Closed-form expansion, conditional expectation, and option valuation
- General approximation schemes for option prices in stochastic volatility models
- Exact and approximate solutions for options with time-dependent stochastic volatility
- Closed-form optimal strategies of continuous-time options with stochastic differential equations
- Closed Form Pricing of European Options for a Family of Normal-Inverse Gaussian Processes
- Higher order approximation of option prices in Barndorff-Nielsen and Shephard models
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