Derivative Evaluation Using Recombining Trees Under Stochastic Volatility

Published in: Advances and Applications in Statistical Sciences, Volume 1, Issue 2, February 2010, pp. 453-480

24 Pages Posted: 21 Apr 2013  

Enrico Moretto

University of Insubria - Department of Economics; CNR - IMATI

Sara Pasquali

CNR-IMATI

Barbara Trivellato

Polytechnic University of Turin - Dipartimento di Matematica

Date Written: August 20, 2009

Abstract

Heston (1993) presents a method to derive a closed-form solution for derivative pricing when the volatility of the underlying asset follows stochastic dynamics. His approach works well for European derivatives but, unfortunately, does not readily extend to the pricing of more complex contracts. In this paper we propose an alternative stochastic volatility model which retains many features of Heston model, but is better suited for an easy discretization through recombining trees, in the spirit of Nelson and Ramaswamy (1990). After having discussed the theoretical properties of the model we construct its discretized counterpart through a recombining multinomial tree. We apply the model to the USD/EURO exchange rate market, evaluating both American and barrier options.

Keywords: exotic option pricing, stochastic volatility, recombining trees

Suggested Citation

Moretto, Enrico and Pasquali, Sara and Trivellato, Barbara, Derivative Evaluation Using Recombining Trees Under Stochastic Volatility (August 20, 2009). Published in: Advances and Applications in Statistical Sciences, Volume 1, Issue 2, February 2010, pp. 453-480. Available at SSRN: https://ssrn.com/abstract=2254267

Enrico Moretto (Contact Author)

University of Insubria - Department of Economics ( email )

Via Ravasi 2
Varese, 21100
Italy

CNR - IMATI ( email )

via Bassini 15
Milano, 20133
Italy

Sara Pasquali

CNR-IMATI ( email )

via Bassini 15
Milano, 20133
Italy

Barbara Trivellato

Polytechnic University of Turin - Dipartimento di Matematica ( email )

Corso Duca degli Abruzzi, 24
Torino, Torino 10129
Italy

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