A closed-form solution for options with stochastic volatility with applications to bond and currency options |
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Authors: | Heston SL |
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Institution: | Yale School of Organization and Management, 135 Prospect street, New Haven, CT 06511, USA |
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Abstract: | I use a new technique to derive a closed-form solution for theprice of a European call option on an asset with stochasticvolatility. The model allows arbitrary correlation between volatilityand spot asset returns. I introduce stochastic interest ratesand show how to apply the model to bond options and foreigncurrency options. Simulations show that correlation betweenvolatility and the spot asset's price is important for explainingreturn skewness and strike-price biases in the Black-Scholes(1973) model. The solution technique is based on characteristicfunctions and can be applied to other problems |
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