A General Decomposition Formula for Derivative Prices in Stochastic Volatility Models
UPF Economics and Business Working Paper No. 665
13 Pages Posted: 17 Oct 2003
Date Written: 2003
We see that the price of a European call option in a stochastic volatility framework can be decomposed in the sum of four terms, which identify the main features of the market that affect option prices: the expected future volatility, the correlation between the volatility and the noise driving the stock prices, the market price of volatility risk and the difference of the expected future volatility at different times. We also study some applications of this decomposition.
Keywords: Continuous-time option pricing model, stochastic volatility, Ito's formula, incomplete markets.
JEL Classification: G130
Suggested Citation: Suggested Citation
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