The Heston Stochastic-Local Volatility Model: Efficient Monte Carlo Simulation
25 Pages Posted: 13 Jun 2013 Last revised: 20 May 2018
Date Written: November 19, 2013
In this article we propose an efficient Monte Carlo scheme for simulating the stochastic volatility model of Heston (1993) enhanced by a non-parametric local volatility component. This hybrid model combines the main advantages of the Heston model and the local volatility model introduced by Dupire (1994) and Derman & Kani (1998). In particular, the additional local volatility component acts as a "compensator" that bridges the mismatch between the non-perfectly calibrated Heston model and the market quotes for European-type options. By means of numerical experiments we show that our scheme enables a consistent and fast pricing of products that are sensitive to the forward volatility skew. Detailed error analysis is also provided.
Keywords: Heston Stochastic-Local Volatility, HSLV, Stochastic Volatility, Local Volatility, Heston, Hybrid Models, Calibration, Monte Carlo
JEL Classification: C63, G12, G13
Suggested Citation: Suggested Citation