A Stochastic Correlation Model with Mean Reversion for Pricing Multi-Asset Options |
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Authors: | Jun Ma |
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Institution: | (1) Temasek Laboratories, National University of Singapore, 5, Sport Drive 2, Singapore, 117508, Singapore |
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Abstract: | We set up a new kind of model to price the multi-asset options. A square root process fluctuating around its mean value is
introduced to describe the random evolution of correlation between two assets. In this stochastic correlation model with mean
reversion term, the correlation is a random walk within the region from −1 to 1, and it is centered around its equilibrium
value. The trading strategy to hedge the correlation risk is discussed. Since a solution of high-dimensional partial differential
equation may be impossible, the Quasi-Monte Carlo and Monte Carlo methods are introduced to compute the multi-asset option
price as well. Taking a better-of two asset rainbow as an example, we compare our results with the price obtained by the Black–Scholes
model with constant correlation. |
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Keywords: | Mean reversion Stochastic correlation Multi-assetoption |
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