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    Heston Model: Sankarshan Basu Professor of Finance Indian Institute of Management Bangalore

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    miku hrsh
    The document discusses the Heston stochastic volatility model. It describes the model's equations where the stock price (S) and volatility (V) are stochastic processes driven by Brownian motions with correlation ρ. V is a mean-reverting process. The model allows for non-normal distributions by varying ρ, σ, and κ. It provides motivations for the model by addressing shortcomings of the Black-Scholes model and describing how the parameters affect the distribution. Finally, it presents the partial differential equation and closed-form solution for European call options under this model.

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    Heston Model: Sankarshan Basu Professor of Finance Indian Institute of Management Bangalore

    Uploaded by

    miku hrsh
    26 views3 pages
    The document discusses the Heston stochastic volatility model. It describes the model's equations where the stock price (S) and volatility (V) are stochastic processes driven by Brownian motions with correlation ρ. V is a mean-reverting process. The model allows for non-normal distributions by varying ρ, σ, and κ. It provides motivations for the model by addressing shortcomings of the Black-Scholes model and describing how the parameters affect the distribution. Finally, it presents the partial differential equation and closed-form solution for European call options under this model.

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    Heston Model

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    The document discusses the Heston stochastic volatility model. It describes the model's equations where the stock price (S) and volatility (V) are stochastic processes driven by Brownian motions with correlation ρ. V is a mean-reverting process. The model allows for non-normal distributions by varying ρ, σ, and κ. It provides motivations for the model by addressing shortcomings of the Black-Scholes model and describing how the parameters affect the distribution. Finally, it presents the partial differential equation and closed-form solution for European call options under this model.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    26 views3 pages

    Heston Model: Sankarshan Basu Professor of Finance Indian Institute of Management Bangalore

    Uploaded by

    miku hrsh
    The document discusses the Heston stochastic volatility model. It describes the model's equations where the stock price (S) and volatility (V) are stochastic processes driven by Brownian motions with correlation ρ. V is a mean-reverting process. The model allows for non-normal distributions by varying ρ, σ, and κ. It provides motivations for the model by addressing shortcomings of the Black-Scholes model and describing how the parameters affect the distribution. Finally, it presents the partial differential equation and closed-form solution for European call options under this model.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 3

    28-11-2020

    Heston Model

    Sankarshan Basu
    Professor of Finance
    Indian Institute of Management
    Bangalore

    Stochastic Volatility Model

    dS  μS dt  V S dW1
    t t t t t
    dV  κ(θ  V )dt  σ V dW2
    t t t t
    dW1dW2  ρdt
    t t
    where,S and V are priceand volatility processes.
    t t
    W1 and W2are Brownianmotion processeswith correlation ρ.
    t t
    V is a square- root mean revertingprocesswith long- run mean θ and rate of reversionκ.
    t
     is the volatility of volatility.

    Motivations
    • Departure from normality (as assumed in
    BSOPM)
    - Empirical studies have shown that an asset’s log-
    return distribution is non-Gaussian. The
    distribution is leptokurtic with fat tails and high
    peaks.
    • Heston model can imply a number of
    distributions by varying ρ, σ and κ. So, the model
    is very robust and addresses the shortcomings of
    the BSOPM.

    1
    28-11-2020

    Motivations
    - ρ can be interpreted as the correlation between
    the log-returns and volatility of the asset
    affecting the fatness of tails.
    - If ρ > 0, volatility increases when asset
    price/return increases, spreading the right tail
    and squeezing the left tail creating a fat right-
    tailed distribution.
    - If ρ < 0, volatility increases when asset
    price/return decreases, spreading the left tail and
    squeezing the right tail creating a fat left-tailed
    distribution.

    Motivations
    - σ affects the kurtosis of the distribution. When σ
    = 0, the volatility is deterministic and hence the
    log-returns will be normally distributed.
    Increasing σ will increase the kurtosis only,
    creating heavy tails on both sides.
    - κ, the mean reversion parameter, can be
    interpreted as representing the degree of
    volatility clustering meaning large price variations
    are more likely to be followed by large price
    variations as observed in the market.

    Partial Differential Equation


    The value of any option, U(St , Vt , t, T) must satisfy the following PDE.
    1 2 2U 2U 1 2  2U U
    VS  ρσVS  σ V 2  rS
    2 S2 SV 2 V S

     κ(θ  V)  Λ(S, V, t)σ V U
    V
     rU 
    U
    t
    0

    Λ(S, V, t) is called the market price of volatilit y risk.


    Heston assumes that this is proportional to volatility.
    Λ(S, V, t)  k V for some constant k
     Λ(S, V, t) V  kVt   (S, V, t)
     (S, V, t) represents market price of volatility risk.
    This is nearly impossible to estimate.

    2
    28-11-2020

    Closed-Form Solution for European Call Options


    on Non-dividend Paying Asset
    C(S t , V t , T, T)  S t P 1  Ke -r(T - t)
    P2
    where,
    1 1  e - i  ln(K) f j (x, V t , T,  )
    P j (x, V t , T,  )    Re( )d 
    2 π 0 i
    x  ln( S t )
    f j (x, V t , T,  )  exp C(T - t,  )  D(T - t,  )V t  i  x 
    a  1 - ge dr 
    C(T - t,  )  r  i τ  (b j  ρσ  i  d) τ - 2ln( )
    σ 2  1 - g 
    b j  ρσ  i  d 1  e dr
    D(T - t,  )  ( )
     2 1  ge dr
    b j  ρσ  i  d
    τ  T - t, g  , d  ( ρσ  i - b j ) 2   2 ( 2 u j i -  2 ) 
    b j  ρσ  i - d
    1 1
    for j  1,2, u 1  ,u 2
      , a  κκθ b 1  κ     , b 2  κ  
    2 2

    Reference
    • Title of paper – “A Closed-Form Solution for
    Options with Stochastic Volatility with
    Applications to Bond and Currency Options”
    • Author – Steven L. Heston
    • Source – The Review of Financial Studies, Vol.
    6, No. 2 (1993), pp. 327-343

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