Department of Economics and Business - Universitat Pompeu Fabra

Title:: A decomposition formula for option prices in the Heston model and applications to option pricing approximation
Author:: Elisa AlÃ²s
Date:: December 2009
Abstract:: By means of classical Itô's calculus we decompose option prices as the sum of the classical Black-Scholes formula with volatility parameter equal to the root-mean-square future average volatility plus a term due by correlation and a term due to the volatility of the volatility. This decomposition allows us to develop first and second-order approximation formulas for option prices and implied volatilities in the Heston volatility framework, as well as to study their accuracy. Numerical examples are given.
Keywords:: Stochastic Volatility, Heston Model, ItÃ´'s Calculus.
JEL codes:: G13
Area of Research:: Statistics, Econometrics and Quantitative Methods

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