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A decomposition formula for option prices in the Heston model and applications to option pricing approximation
Authors:Elisa Alòs
Institution:1. Dpt. d??Economia i Empresa, Universitat Pompeu Fabra, c/Ram??n Trias Fargas, 25-27, 08005, Barcelona, Spain
Abstract:By means of classical It? calculus, we decompose option prices as the sum of the classical Black?CScholes formula, with volatility parameter equal to the root-mean-square future average volatility, plus a term due to 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 for short maturities. Numerical examples are given.
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