Convergence Analysis for Continuous-Time Markov Chain Approximation of Stochastic Local Volatility Models: Option Pricing and Greeks

Abstract

This paper establishes the precise second order convergence rates of the continuous-time Markov chain (CTMC) approximation method for pricing options and calculating its Greeks under the general framework of stochastic local volatility models, which include the Heston and SABR models as special cases. Numerical examples confirm the theoretical findings.

Keywords: Continuous-time Markov chains, stochastic local volatility models, option pric-ing, Greeks, convergence rates

JEL Classification: C63, G13