Option Pricing with Mean Reversion and Stochastic Volatility
Hoi Ying Wong
Chinese University of Hong Kong (CUHK) - Department of Statistics
Yu Wai Lo
affiliation not provided to SSRN
January 23, 2008
European Journal of Operational Research 197, 179-187, 2009
Many underlying assets of option contracts, such as currencies, commodities, energy, temperature and even some stocks, exhibit both mean reversion and stochastic volatility. This paper investigates the valuation of options when the underlying asset follows a mean-reverting lognormal process with stochastic volatility. A closed-form solution is derived for European options by means of Fourier transform. The proposed model allows the option pricing formula to capture both the term structure of futures prices and the market implied volatility smile within a unified framework. A bivariate trinomial lattice approach is introduced to value path-dependent options with the proposed model. Numerical examples using European options, American options and barrier options demonstrate the use of the model and the quality of the numerical scheme.
Number of Pages in PDF File: 25
Keywords: Option Pricing, Mean Reversion, Stochastic Volatilityworking papers series
Date posted: March 28, 2008 ; Last revised: February 13, 2009
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