Pricing the European call option in the model with stochastic volatility driven by Ornstein-Uhlenbeck process. Exact formulas (Q340779)

On of the promising direction of enhancement of the classical Black-Scholes model is a construction and a research of diffusion models with volatility of risky asset governed by a stochastic process. In the presented paper the Black-Scholes model of financial market modified to capture the stochastic nature of volatility observed at real financial markets is considered. For volatility driven by the Ornstein-Uhlenbeck process the existence of equivalent martingale measure in the market model is established. The option is priced with respect to the minimal martingale measure for the case of uncorrelated processes of volatility and asset price and an analytic expression for the price of European call option is derived. In the Introduction the classical Black-Scholes model is discussed. Also, the stochastic volatility modification of this model is considered. The questions of existence of equivalent martingale measures are given and analysed. In Section 2 the concept of the diffusion model with stochastic volatility governed by the Ornstein-Uhlenbeck process is presented. Here, the model of the market, where one risky asset is traded, is described by the pair of stochastic differential equations \[ d S_t = \mu S_t dt + \sigma(Y_y) S_t dB_t, \eqno{(1)} \] \[ d Y_t = - \alpha Y_y dt + k d W_t, \eqno{(2)} \] where \(\{S_t: 0 \leq t \leq T\}\) is the geometric Brownian motion and \(\{B_t, W_t: 0 \leq t \leq T\}\) are Wiener processes. Also, the initial conditions of the processes (1)--(2) are given. In Section 3 definitions and preliminary results necessary for further analysis are presented. Two theorems that establish necessary and sufficient conditions for the absence of arbitrage in the market in terms of equivalent martingale measures are given. Section 4 matters of the existence of equivalent martingale measures and arbitrage properties of the general model are investigated. In Section 5 a particular case of the general model and raise the problem of pricing European call option is defined. Here, the simplifies the risk-neutral model is given in the form: \[ \begin{aligned} d S_t & = r S_t dt + \sigma(Y_t) S_t B_t^{Q},\\ d Y_t & = (- \alpha Y_y - k \nu(t)) dt + k d Z_t^{Q} \end{aligned} \eqno{(3)} \] with concrete definition of \(B_t^{Q}\) and \(Z_t^{Q}.\) In Theorem 5.1 the European call option in the model (3) is priced. Section 6 covers the derivation of an analytical expression for the option price. In Theorem 6.1 for the market defined by the model (3), under proposed assumptions, a presentation of the price at time 0 of the European call option \(V_0\) is given.