Heston (1993) presents a method to derive a closed-form solution for derivative pricing when the volatility of the underlying asset follows stochastic dynamics. His approach works well for European derivatives but, unfortunately, does not readily extend to the pricing of more complex contracts. In this paper we propose an alternative stochastic volatility model which retains many features of Heston model, but is better suited for an easy discretization through recombining trees, in the spirit of Nelson and Ramaswamy (1990). After having discussed the theoretical properties of the model we construct its discretized counterpart through a recombining multinomial tree. We apply the model to the USD/EURO exchange rate market, evaluating both American and barrier options.
Moretto, E., Pasquali, S., Trivellato, B. (2010). Derivative evaluation using recombining trees under stochastic volatility. ADVANCES AND APPLICATIONS IN STATISTICAL SCIENCES, 1(2), 453-480.
Derivative evaluation using recombining trees under stochastic volatility
Moretto, Enrico.;
2010
Abstract
Heston (1993) presents a method to derive a closed-form solution for derivative pricing when the volatility of the underlying asset follows stochastic dynamics. His approach works well for European derivatives but, unfortunately, does not readily extend to the pricing of more complex contracts. In this paper we propose an alternative stochastic volatility model which retains many features of Heston model, but is better suited for an easy discretization through recombining trees, in the spirit of Nelson and Ramaswamy (1990). After having discussed the theoretical properties of the model we construct its discretized counterpart through a recombining multinomial tree. We apply the model to the USD/EURO exchange rate market, evaluating both American and barrier options.File | Dimensione | Formato | |
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