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A decomposition formula for option prices in the Heston model and applications to option pricing approximation
Alòs, Elisa
Universitat Pompeu Fabra. Departament d'Economia i Empresa
By means of classical Itô's calculus we decompose option prices asthe sum of the classical Black-Scholes formula with volatility parameterequal to the root-mean-square future average volatility plus a term dueby correlation and a term due to the volatility of the volatility. Thisdecomposition allows us to develop first and second-order approximationformulas for option prices and implied volatilities in the Heston volatilityframework, as well as to study their accuracy. Numerical examples aregiven.
Statistics, Econometrics and Quantitative Methods
stochastic volatility
heston model
itô's calculus.
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