Abstract
A general method to construct recombinant tree approximations for stochastic volatility models is developed and applied to the Heston model for stock price dynamics. In this application, the resulting approximation is a four tuple Markov process. The first two components are related to the stock and volatility processes and take values in a two-dimensional binomial tree. The other two components of the Markov process are the increments of random walks with simple values in {-1,+1}. The resulting efficient option pricing equations are numerically implemented for general American and European options including the standard put and calls, barrier, lookback and Asian-Type pay-offs. The weak and extended weak convergences are also proved.
Original language | English |
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Pages (from-to) | 2176-2205 |
Number of pages | 30 |
Journal | Annals of Applied Probability |
Volume | 24 |
Issue number | 5 |
DOIs | |
State | Published - Oct 2014 |
Externally published | Yes |
Keywords
- Heston model
- Recombinant trees
- Stochastic volatility
- Weak convergence