Chapter 4

Stochastic Volatility Models

4.1 The Hestons (1993) Model
The Hestons model represents one of the most important progresses in tackling the chal-
lenge in option pricing after the 1987 crash, when volatility smiles had become a persistence
existence. The Hestons model is largely based on nancial economical considerations: the
volatility is stochastic positive and bounded in a range. Its popularity, however, is largely
due to the capacity of analytical solution for many options.
The Hestons model consists of
_
_
_
dS
t
=
t
S
t
dt +
t
S
t
dW
t
d
t
=
t

t
dt +
t
dZ
t
dW
t
dZ
t
=
t
dt
(4.1.1)
The volatility follows an Ornstein-Uhlenbeck process, which was rst adopted by Stein and
Stein (1991). In most literature, variance, V (t) =
2
t
, is used in place of
t
. By Itos lemma,
the variance follows
dV (t) = [
2
t
2
t
V (t)]dt + 2
t
_
V (t)dZ
t
. (4.1.2)
People like to recast (4.1.1) and (4.1.2) into
_
dS
t
=
t
S
t
dt +

V
t
S
t
dW
t
dV
t
= (

V
t
)dt +
t

V
t
dZ
t
.
(4.1.3)
Note that from now on
t
is used for the volatility of volatility instead the volatility of the
equity.
For simplicity we assume constant interest rate. Then the value of any asset U(S, V, t)
satises
U
t
+
1
2
V S
2

2
U
S
2
+ V S

2
U
SV
+
1
2

2
V

2
U
V
2
+ rS
U
S
+ (S, V, t)
U
V
rU = 0.
1
2 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
We now need to specify the risk premium for stochastic volatility, (S, V, t). According
to the equilibrium arguments in Chapter 3, we assume that the market price of volatility risk
is proportional to the volatility, i.e.,

V
t
, yielding
(S, V
t
, t) = (

V
t
) +
_
V
t

t
_
V
t
(4.1.4)
= ( V
t
). (4.1.5)
Here,
= (1 +
t
), =

/(1 +
t
).
In practice, is determined by calibrating the model to liquid volatility-dependent assets.
The risk-neutral process for the volatility becomes
dV
t
= [ V
t
]dt +
_
V
t
dZ
t
.
4.1.1 Moment Generating Function
Let X
t
= ln (S
t
/S
0
). The moment generating function of X
t
is dened by
(X
t
, V (t), t; z) := E[e
zX(T)
|F
t
], z C.
It is known that the MGF satises the Kolmogorov backward equation corresponding to
the joint process:

t
+ ( V )

V

1
2
V

X
+
1
2

2
V

2

V
2
+ V

2

V X
+
1
2
V

2

X
2
= 0 (4.1.6)
subject to the terminal condition
(x, V, T; z) = e
zx
. (4.1.7)
Following Heston (1993), we consider solution of the form

(x, V, ; z) = e
A(,z)+B(,z)V +zx
(= (x, V, t; z)) .
Here, = T t is the time to maturity. Substituting the above formal solution to (4.1.6,
4.1.7):
dA
d
= B
dB
d
=
1
2

2
B
2
+ (z )B +
1
2
(z
2
z)
subject to
A(0, z) = 0, B(0, z) = 0.
The equation for B is called a Riccati equation which is known to have analytical solution
for constant coecients.
4.1. THE HESTONS (1993) MODEL 3
4.1.2 Solution of the Riccati Equation
Proposition 4.1 For constant coecients with = 0, equations (4.1.6, 4.1.7) admits a
unique solution of the form
A(, z) = A(0, ) +

2
_
(a + d) 2 ln
_
1 ge
d
1 g
__
B(, z) = B(0, ) +
(a + d
2
B(0, z))(1 e
d
)

2
(1 ge
d
)
where
a = z, d =
_
a
2

2
(z
2
z), g =
a + d
2
B(0, z)
a d
2
B(0, z)
.
Note that

T
(z) = (0, V, 0; z) =

(0, V, T; z).
Proof For clarity, we let
a = , b
0
=
1
2
(z
2
z), b
1
= z , b
2
=
1
2

2
and consider
_

_
dA
d
= aB
dB
d
= b
2
B
2
+ b
1
B + b
0
.
(4.1.8)
subject to initial conditions
A(0) = A
0
, B(0) = B
0
.
B is independent of A and thus will be solved rst. In the special case when
b
2
B
2
0
+ b
1
B
0
+ b
0
= 0,
we have an easy solution
B() = B
0
A() = A
0
+ a
0
B
0
.
Otherwise, we let Y
1
be the solution to
b
2
Y
2
+ b
1
Y + b
0
= 0.
Then
Y
1
=
b
1

2b
2
, with =
_
b
1
4b
0
b
2
.
4 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
Without making a dierence, we choose + sign for Y
1
. We then consider the dierence
between B and Y
1
:
Y
2
= B Y
1
,
which satises
dY
2
d
=
d(Y
1
+ Y
2
)
d
= b
2
(Y
1
+ Y
2
)
2
+ b
1
(Y
1
+ Y
2
) + b
0
= b
2
Y
2
2
+ (2b
2
Y
1
+ b
1
)Y
2
= b
2
Y
2
2
+ Y
2
(4.1.9)
with initial condition
Y
2
(0) = B
0
Y
1
.
Equation (4.1.9) is called Bernoulli equation and can be solved explicitly: Divide both
sides by Y
2
2
,
d
d
_

1
Y
2
_
= b
2

1
Y
2
_
.
Let Z = 1/Y
2
, then
dZ
d
= b
2
Z
d(e

) = e

b
2
.
Integrating
e

Z Z(0) =
b
2

(e

1)
Z() = e

Z(0) +
b
2

(1 e

)
=
b
2

+
_
Z(0)
b
2

_
e

.
It follows that
Y
2
() =
1
b
2

+
_
Z(0)
b
2

_
e

=
1
b
2

+
_
1
B
0
Y
+
1

1
Y
+
1
Y

1
_
e

=
(Y
+
1
Y

1
)
1 +
_
Y

1
Y
+
1
B
0
Y
+
1
1
_
e

=
Y

1
Y
+
1
1 +
_
Y

1
Y
+
1
B
0
+Y

1
B
0
Y
+
1
_
e

=
Y

1
Y
+
1
1
_
B
0
Y

1
B
0
Y
+
1
_
e

4.1. THE HESTONS (1993) MODEL 5

Let g =
B
0
Y

1
B
0
Y
+
1
. Then
B() = Y
+
1
+ Y
2
()
= B
0
+
Y

1
Y
+
1
1 ge

+ Y
+
1
B
0
= B
0
+
Y

1
Y
+
1
+ Y
+
1
B
0
g(Y
+
1
B
0
)e

1 ge

= B
0
+
(Y

1
B
0
)(1 e

)
1 ge

= B
0
+
(Y
+
1
B
0
)(1 e

)
1 ge

where g = 1/ g.
Having obtained B(), we integrate (4.1.8) to get A:
A() = A
0
+ a
0
_

0
B(s)ds
= A
0
+ a
0
B
0
+ a
0
(Y
+
1
B
0
)
_

0
1 e
s
1 ge
s
ds
= A
0
+ a
0
B
0
+ (Y
+
1
B
0
)
_
+
_

0
(g 1)e
s
1 ge
s
ds
_
= A
0
+ a
0
Y
+
1
+ (Y
+
1
B
0
)
(g 1)

_
e
s
1
du
1 gu
= A
0
+ a
0
Y
+
1
+ (Y
+
1
B
0
)
(g 1)
g
[ln(1 gu)]
e

1
= A
0
+ a
0
Y
+
1
+ (Y
+
1
B
0
)
(g 1)
g
ln
_
1 ge

1 g
_
.
Substituting a
0
, b
0
, b
1
and b
2
by
a
0
= , b
0
=
1
2
(z
2
z), b
1
= z , b
2
=
1
2

2
,
we arrive at the expression of the solution.
6 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
4.1.3 Option Pricing Under the Hestons Model
For simplicity we assume constant interest rate. Then, the price of a call option can be
expressed as
C = e
rT
E
0
_
(S
T
K)
+

= e
rT
S
0
E
0
_
_
S
T
S
0

K
S
0
_
+
_
= e
rT
S
0
_
E
0
_
e
X
T
1
{S
T
>K}

K
S
0
E
0
_
1
{S
T
>K}

_
.
Based on the moment generating function of X
T
, we have
Proposition 4.2 Let
(X(t), V (t), t; Z) = E
_
e
ZX(T)
|
Ft

be the moment generating function of X(T) and let

T
(Z) = (0, V (0), 0; Z). Then
E
0
_
1
{S
T
>K}

=

T
(0)
2
+
1

_

0
Im
_
e
iuln
K
S
0

T
(iu)
_
u
du
E
0
_
e
X(T)
1
{S
T
>K}

=

T
(1)
2
+
1

_

0
Im
_
e
iuln
K
S
0

T
(1 + iu)
_
u
du.
Proof We try to prove in generality that
E
0
_
e
X(T)
1
{X
T
>X
0
}

=

T
()
2
+
1

_

0
Im
_
e
iulnX
0

T
( + iu)
_
u
du.
Let q
T
(x) be the probability density function of X(T). By denition,
E
0
_
e
X(T)
1
{X
T
>X
0
}

=
_

X
0
e
x
q
T
(x)dx
=
_

X
0
1
2
_

e
iux

T
( + iu)dudx
= lim
A
1
2
_

T
( + iu)
_
A
X
0
e
iux
dxdu
= lim
A
1
2
_

T
( + iu)
e
iuA
e
iuX
0
iu
du
= lim
A
1
2
_

T
( + iu)
e
iuA
iu
du +
1
2
_

T
( + iu)
e
iuX
0
iu
du
= I + II.
4.1. THE HESTONS (1993) MODEL 7
We work on II rst
II =
1
2
__
0

+
_

0

T
( + iu)
e
iuX
0
iu
du
_
=
1
2
__
0

T
( iu)
e
+iuX
0
iu
d(u) +
_

0

T
( + iu)
e
iuX
0
iu
du
_
=
1
2
_

0

T
( iu)e
+iuX
0
+
T
( + iu)e
iuX
0
iu
du
=
1
2
_

0

T
( + iu)e
iuX
0

T
( + iu)e
+iuX
0
iu
du
=
1

_

0
Im
_

T
( + iu)e
iuX
0
_
u
du
For I, we have
I = lim
A
1
2
_
|u|<
+
_
|u|>

T
( + iu)
e
iuA
iu
du
=
1
2
lim
A
_
|u|<

T
( + iu)
e
iuA
iu
du
=
1

lim
A
_

0
Im
_

T
()e
iuA
_
iu
du
+
_

0
Im
_
(
T
( + iu)
T
()) e
iuA
_
u
du
=
1

T
() lim
A
_

0
sin uA
u
du
+
1

lim
A
_

0
Im(

T
( + i u)(iu))
u
du
=

T
()
2
.
During the proof, we have used the following properties of
T
.
Properties of
T
(Z) and others.
1.
T
( iu) =
T
( + iu),
2. The rst moment of
T
exists

T
(Z) = E
_
e
ZX
T
X
T

.
8 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
3. There is
1

_

0
sin t
t
dt =
_

_
1
2
, > 0,
0, = 0,

1
2
, < 0.
(4.1.10)
Presumably, having obtained
T
in closed form, the valuation of call options becomes an
issue of numerical integration.
4.1.4 The Laplace Transform of Call Option
European call/put options can be seen as convolutions of the payo functions and the density
functions. If the Fourier transforms of the two functions exist, then the Fourier transform of
the option also exist in closed form.
Consider the normalized price of a call option
C
T
(k) = E
Q
0
__
S
T
S
0

K
S
0
__
= E
Q
0
__
e
X
T
e
k
_
=
_

k
(e
s
e
k
)q
T
(s)ds.
Note that C
T
(k) is not square integrable over (, ) as it tends to 1 when k .
4.1. THE HESTONS (1993) MODEL 9
Hence, we choose an a > 0 and perform Laplace transform on C
T
(k):
(u)

=
_

e
(a+iu)k
C
T
(k)dk
=
_

e
(a+iu)k
E
Q
0
__
e
X
T
e
k
_
= E
Q
t
__

e
(a+iu)k
_
e
X
T
e
k
_
+
dk
_
= E
Q
t
__
X
T

e
(a+iu)k
_
e
X
T
e
k
_
dk
_
= E
Q
t
_
e
X
T
a + iu
e
(a+iu)k

X
T

1
1 + a + iu
e
(1+a+iu)k

X
T

_
= E
Q
t
__
1
a + iu

1
1 + a + iu
_
e
(1+a+iu)X
T
_
=
1
(a + iu)(1 +a + iu)
E
Q
t
_
e
(1+a+iu)X
T

=
1
(a + iu)(1 +a + iu)

T
(1 + a + iu)
The value of C
T
(k) can then be obtained via inverse Laplace transform:
C
T
(k) =
1

_

0
e
(a+iu)k
(u)du
=
e
ak

_

0
e
iuk
(u)du (4.1.11)
4.1.5 Fast Fourier Transform for Option Valuation
To evaluate the integral in (4.1.11) numerically, we need to truncate the innite domain at
a nite number. To choose this number, say, A, let us estimate the error of the numerical
integration caused by the truncation. Let Z = 1 + a and assume X
t
= 0. According to the
denition of
T
(), we have
|
T
(1 + a + iu)| |
T
(1 + a)| =

E
Q
_
e
(1+a)X
T

= E
Q
_
_
S
T
S
0
_
1+a
_

_
E
Q
__
S
T
S
0
___
1+a
= 1.
10 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
It follows that
|(u)|

1
(a + iu)(1 +a + iu)

1
a
2
+ u
2
and

_

A
e
iuk
(u)du

_

A
1
a
2
+ u
2
du
1
A
.
Hence, it suces to take A = 10
4
. This estimate, however, is too conservative.
Having a truncation at A, we can now proceed to numerical scheme. We consider the
composit trapezoidal rule for the numerical integration:
H(k)

=
1

_
(0)
2
+
N1

m=1
e
iumk
(u
m
) +
e
iu
N
k
(u
N
)
2
_
u
where u
m
= mu and u = A/N. We are interested mainly in the around-the-money
options, thus we take
k
n
= b + nk for some b > 0, n = 0, , N 1,
with k = 2bN. For n = 0, 1, , N 1, we have
H(k
n
) =
1

_
(0)
2
+
N1

m=1
e
iukmn
_
e
ibum
(u
m
)

+
e
iukNm
e
ibu
N
(u
N
)
2
_
u.
We choose, in particular,
uk =
2
N
, or b =
N
A
,
which results in
H(k
n
) =
1

_
(0) +e
ibu
N
(u
N
)
2
+
N1

m=1
e
i
2
N
mn
_
e
ibum
(u
m
)

_
u, n = 0, 1, , N 1.
The expression of H(k
n
) ts into the denition of discrete Fourier transform, and can be
realized through FFT (Press et al . , 1992).
4.2 Option Pricing by Transformation Methods
The results of this section hold for stochastic interest rates. Let X
t
= ln S
t
be the return of
the asset. We considder pricing options with the following payos
G
1
(x, k) = (exp(x) exp(k))
+
G
2
(x, k) = (x k)
+
G
3
(x, k) = exp(b
1
x)1
{b
0
x>k}
G
4
(x, k) = (b
2
x) exp(b
1
x)1
{b
0
x>k}
4.2. OPTION PRICING BY TRANSFORMATION METHODS 11
Here, G
1
represents the usual call options on an asset, G
2
includes options on returns or yields,
G
3
includes digital, exchange, maximum options, G
4
includes basket and spread options.
4.2.1 The Discounted Moment Generating Function
Dene the discounted moment generating function (MGF)
f( + iu) = E
Q
_
e

_
T
0
rtdt
e
(+iu)x
_
under the risk-neutral measure Q. Note that
f( + iu) = f(0)E
Q
T
_
e
(+iu)x

,
where Q
T
is the T-forward measure, and f(0) = P(0, T). We make the following assumption.
Assumption: The discounted MGF f is well-dened, and partial derivatives of f may
be taken through the expectation.
This assumption is known to be true for a very general class of asset price models under
stochastic interest rates, e.g., the ane models. For conditions such that the assumption
holds, we refer readers to Zemanian (1966)
1
.
4.2.2 Laplace Transform of the Option Prices
As the principle an option price is given by
C
G
= P(0, T)E
Q
T
[G(X
T
, k)].
Since Fourier transform of C
G
may not exist, we consider instead the Laplace transform. Let
> 0 be some constant. Dene the Laplace transform of the option by

C
,G
(u)

=
_

e
(+iu)k
C
G
(k)dk
Given the discounted moment generating function of the state variable, we have
1
See Theorem 4 and 5
12 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
Theorem 4.3 For an > 0, Laplace transforms of the options exist and are given by

C
,G
1
(u) =
f(1 + + iu)
( + iu)
2
+ + iu

C
,G
2
(u) =
f( + iu)
( + iu)
2

C
,G
3
(u) =
f(b
0
+ b
1
+ iub
0
)
+ iu

C
,G
4
(u) =
ib
2
f(b
0
+ b
1
+ iub
0
)
+ iu
.
Proof The integrand decays exponentially as |k| , so the integral exist. Moreover, we
use the Fubinis theorem in real analysis to exchange the order or integration and expectation:

C
G
(u) :=
_

e
(+iu)k
C
,G
(k)dk
=
_

e
(+iu)k
P(0, T)E
Q
T
[G(X, k)] dk
= f(0)E
Q
T
__

G(X, k)e
(+iu)k
dk
_
.
In a previous section, we have already derived

C
,G
1
(u). Next we derive

C
,G
2
(u).
E
Q
T
__

G(X, k)e
(+iu)k
dk
_
= E
Q
T
__

(X
T
k)
+
e
(+iu)k
dk
_
= E
Q
T
__
X
T

(X
T
k)
+
e
(+iu)k
dk
_
= E
Q
T
_
X
T
e
(+iu)k
+ iu

X
T

ke
(+iu)k
+ iu

X
T

+
_

e
(+iu)k
+ iu
dk
_
=
E
Q
T
[e
(+iu)X
T
]
( + iu)
2
.
The result on

C
,G
2
(u) then follows. Similarly, by direct evaluating the other two integrals,
4.2. OPTION PRICING BY TRANSFORMATION METHODS 13
we have

C
,G
3
(u) =
f(0)E
_
e
(b
0
+b
1
+iub
0
)X

+ iu
=
f(b
0
+ b
1
+ iub
0
)
+ iu

C
,G
4
(u) =
f(0)E
_
(b
2
X)e
b
1
X
e
(+iu)b
0
X

+ iu
=
ib
2
f(b
0
+ b
1
+ iub
0
)
+ iu
.
Once we have obtained the Laplace transform of the option values, we can obtain the
option values themselves by inverse laplace transform. Let
C(k) = [C(k 0) + C(k + 0)] 2
Then
C
G
(k) =
1
2
_

e
(+iu)k

C
,G
(u)du
=
e
k

_

0
Re
_
e
iuk

C
,G
(u)
_
du
14 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
4.3 Calibration of the Hestons Model
At this moment, least-squared error t is the only solution. We take the error function as
SqErr() =
N

i=1
N

j=1
w
ij
[C
MP
(K
i
, T
j
) C
SV
(; K
i
, T
j
)]
2
+ Penalty(,
0
)
where = {, , , , V
0
}. There is a constraint such as
2k
2
> 0
to ensure that the volatility process stays above zero.
Local algorithm (deterministic search)
It can be trapped in a local minimum
Initial guess important
Stochastic algorithm
Initial guess unimportant
By simulated annealing algorithm (that chooses direction and stepwise randomly)
Always moves downhill, but may accept an uphill move with certain probability,
which depends on annealing/temperature parameter T
T
Global convergence
4.4. SIMULATION METHODS WITH THE HESTONS MODEL 15
4.4 Simulation Methods with the Hestons Model
Consider
dS
t
=
t
S
t
dt +
_
V
t
S
t
dW
t
dV
t
= ( V
t
)dt +
_
V
t
dZ
t
We want to simulate the path of {S
t
, V
t
}
t=T
t=0
.
4.4.1 Euler Scheme
The Euler scheme take the form
S
t+t
= S
t
exp
_
(
t

1
2
V
t
)t +
_
V
t
W
t
_
V
t+t
= V
t
+ ( V
t
)t +
_
V
t
Z
t
The naive Euler scheme can break down due to the occurrenceof negative V
t
. There are two
ways for quick xing. We let the boundary V
t
= 0 be either
- Absorbing: V
t
= V
+
t
, or
- Reection: V
t
= |V
t
|
The disadvantage of the modied Euler scheme is its slow convergence.
4.4.2 Milstein Discretization
To alleviate the negative variance, Milstein use Ito-Taylor expansion and propose
V
t+t
= V
t
+ (V
t
)t +
_
V
t
Z +

2
4
_
Z
2
t
_
,
or,
V
t+t
=
_
_
V
t
+

2
Z
_
2
+
_
( V
t
)

2
4
_
t.
Note that if V
t
= 0 and 4/
2
> 1, then V
t+t
> 0, indicating that the frequency of
occurrence of negative variance should be substantially reduced.
Consider an Itos process
dX(t) = a(X(t))dt + b(X(t))dW
t
.
16 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
The Itos lemma is
df(X(t)) =
_
a

X
f(X(t)) +
1
2
b
2

2
X
2
f(X(t))
_
dt
+b(X(t))

X
f(X(t))dW
t

= L
0
f(X(t))dt +L
1
f(X(t))dW
t
,
or,
f(X(t)) = f(X(t
0
)) +
_
t
t
0
L
0
f(X(s))ds +
_
t
t
0
L
1
f(X(s))dW
s
.
Now, consider several special cases,
1. f(x) = x. Then
X(t) = X(t
0
) +
_
t
t
0
a(X(s))ds +
_
t
t
0
b(X(s))dW
s
(4.4.12)
2. f(x) = a(x). Then
a(X(t)) = a(X(t
0
)) +
_
t
t
0
L
0
a(X(s))ds +
_
t
t
0
L
1
a(X(s))dW
s
(4.4.13)
3. f(x) = b(x). Then
b(X(t)) = b(X(t
0
)) +
_
t
t
0
L
0
b(X(s))ds +
_
t
t
0
L
1
b(X(s))dW
s
(4.4.14)
Substitute (4.4.13) and (4.4.14) to (4.4.12), we obtain
X(t) = X(t
0
)
= +
_
t
t
0
_
a(X(t
0
)) +
_
s
1
t
0
L
0
a(X(s
2
))ds
2
+
_
s
1
t
0
L
1
a(X(s))dW(s
2
)
_
ds
1
= +
_
t
t
0
_
b(X(t
0
)) +
_
s
1
t
0
L
0
b(X(s
2
))ds
2
+
_
s
1
t
0
L
1
b(X(s
1
))dW(s
2
)
_
dW(s
1
)
= X(t
0
) + a(X(t
0
))
_
t
t
0
ds
1
+ b(X(t
0
))
_
t
t
0
dW(s
1
) + R.
4.4. SIMULATION METHODS WITH THE HESTONS MODEL 17
Note that
L
0
a = a
a
X
+
1
2
b
2

2
a
X
2
= aa

+
1
2
b
2
a

L
0
b = ab

+
1
2
b
2
b

L
1
a = b
a
X
= ba

L
1
b = b
b
X
= bb

,
where
R =
_
t
t
0
_
s
1
t
0
L
0
a(X(s
2
))ds
2
ds
1
+L
1
a(X(s))dW(s
2
)ds
1
+L
0
a(X(s
2
))ds
2
dW(s
1
) +L
1
b(X(s
2
))dW(s
2
)dW(s
1
).
Note that the last term of R has the lowest order in dt. In fact,
_
t
t
0
_
s
1
t
0
L
1
b(X(s
2
))dW(s
2
)dW(s
1
)
=
_
t
t
0
_
s
1
t
0
_
L
1
b(X(t
0
)) +
_
s
2
t
0
L
0
L
1
b(X(s
3
))ds
3
+
_
s
2
t
0
L
1
L
1
b(X(s
3
))dW(s
3
)
_
dW(s
2
)dW(s
1
)
=
_
t
t
0
_
s
1
t
0
L
1
b(X(t
0
))dW(s
2
)dW(s
1
) + o(t t
0
)
3/2
= b(X(t
0
))b

(X(t
0
))
_
t
t
0
_
s
1
t
0
dW(s
2
)dW(s
1
) + o(t t
0
)
3/2
.
Since
_
t
t
0
_
s
1
t
0
dW(s
2
)dW(s
1
)
=
_
t
t
0
[W(s
1
) W(t
0
)] dW(s
1
)
=
_
t
t
0
W(s
1
)dW(s
1
) W(t
0
)
_
t
t
0
dW(s
1
)
=
1
2
_
t
t
0
_
dW
2
(s
1
) ds
1

W(t
0
)(W(t) W(t
0
))
=
1
2
_
W
2
(t) W
2
(t
0
) (t t
0
)

W(t
0
) [W(t) W(t
0
)]
=
1
2
(W(t) W(t
0
))
2

1
2
(t t
0
).
18 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
We end up with the Ito-Taylor expansion
X(t) = X(t
0
) + a(X(t
0
))(t t
0
) + b(X(t
0
))(W(t) W(t
0
))
+
1
2
b(X(t
0
))b

(X(t
0
))
_
(W(t) W(t
0
)
2
(t t
0
)
_
+

R.
The corresponding scheme for discrete time stepping is
X(t
i+1
) = X(t
i
) + a(X(t
i
))t + b(X(t
i
))W
i
+
1
2
b(X(t
i
))b

(X(t
i
))
_
W
2
i
t

Consider now
dV
t
= ( V
t
)
. .
a(Vt)
dt +
_
V
t
. .
b(Vt)
dZ,
we have
V (t
i+1
) = V (t
i
) + ( V (t
i
))t
i
+
_
V (t
i
)Z
i
+
1
4

2
(Z
2
i
t
i
)
4.4.3 Implicit Scheme of Alfonsi (2005)
We begin with
V
t+t
= V
t
+ ( V
t
)t +
_
V
t
Z
t
= V
t
+ ( V
t
)t +
_
V
t+t
Z
t
+(
_
V
t

_
V
t+t
)Z
t
+ higher order terms
Noticing that
_
V
t+t

_
V
t
=

2
Z
t
+ higher order terms,
we obtain, by substitution
V
t+t
= V
t
+ ( V
t
)t +
_
V
t+t
Z
t

2
2
(t + Z
2
t
t)
= V
t
+ ( V
t
)t +
_
V
t+t
Z
t

2
2
t.
So, V
t+t
is obtained as a root of a quadratic equation
_
V
t+t
=
_
4V
t
+ t [(
2
/2)(1 +t)] +
2
Z
2
+ Z
2(1 +t)
.
If 2/
2
> 1, the root is real and the variance is positive.
Milstein scheme is more preferred.
4.4. SIMULATION METHODS WITH THE HESTONS MODEL 19
4.4.4 Sampling from the Exact Transition Law (Glasserman, 2004)
The exact scheme,
S
t
= S
0
exp{
1
2
_
t
0
V
s
ds +
_
t
0
_
V
s
dW
s
+
_
1
2
_
t
0
_
V
s
dW

s
}
V
t
= V
0
+
_
t
0

s
ds
_
t
0
V
s
ds +
_
t
0
_
V
s
dW
s
where < dW
s
dW

s
>= 0.
4.4.5 The Broadie-Kaya Approach
Generate a sample from the distribution of V
t
given V
0
.
Generate a sample from the distribution of
_
t
0
V
s
ds given V
0
and V
t
.
Recover
_
t
0

V
s
dW
s
given V
0
, V
t
and
_
t
0
V
s
ds.
Generate a sample from the distribution given
_
t
0

V
s
dW
s
and
_
t
0
V
s
ds.
4.4.6 Square Gaussian Models
Let X
i
(t), i = 1, , n be independent Ornstein-Uhlenbeck process of the form
dX
i
(t) =

2
X
i
(t)dt +

2
dW
i
(t), i = 1, , n
for some constants , and independent Brownian motions, W
i
(t). Let
Y (t) =
n

i=1
X
2
i
(t).
Then,
dY (t) =
n

i=1
_
2X
i
(t)dX
i
(t) + [dX
i
(t)]
2
_
=
n

i=1
_
2X
i
(t)dX
i
(t) +

2
4
dt
_
=
n

i=1
_
X
2
i
(t) +

2
4
_
dt +
n

i=1
X
i
(t)dW
i
(t)
=
_

2
n
4
Y (t)
_
dt +

X(t) d

W(t)
20 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
Dene
d

W
t
=

X(t)

X(t)
d

W(t) =

X(t)
_
Y (t)
d

W
t
which is a standard Brownian motion, then
dY (t) =
_

2
n
4
Y (t)
_
dt +
_
Y (t)d

W(t)
is a square-root diusion.
For the square-root process
dV (t) = ( V (t))dt +
_
V (t)dZ
t
,
let
n =
_
4

2
+
1
2
_
then we can approximate V (t) by
V (t
i+1
) =
n

j=1
X
2
j
(t
i+1
)
where
X
j
(t
i+1
) = e

2
t
i
X
j
(t
i
) +

2
_
t
i+1
t
i
e

2
(t
i+1
S)
dW
j
(s)
= e

2
t
i
X
j
(t) +

2

_
t
i
0
e
s
ds
i
= e

2
t
i
X
j
(t) +

2
_
1

(1 e
t
i
)
i
where
i
N(0, 1) are i.i.d. random variables.
In some major application areas like xed income, 4/
2
1 or 2. So by percentage, the
approximation to the drift term of a square-root process is not very accurate, but this does
not aect much of the performance in applications.
4.4.7 The Andersen Schemes
Let
2
(x; , ) denote a non-central chi-square distribution with degree of freedom and
non-centrality parameter . There is (see e.g. Andersen and Piterbarg (2005), Dufresne
(2001) and CIR (1985))
4.4. SIMULATION METHODS WITH THE HESTONS MODEL 21
Proposition 4.4 Let F

2(x; , ) be the cumulative distribution function for the non-central

chi-square distribution with degrees of freedom and non-centrality parameter :
F

2(x; , ) = e
/2

j=0
(/2)
j
j! 2
/2+j
(/2 + j)
_
x
0
x
/2+j1
e
s/2
ds.
When = 0,
F

2(z; , ) =
1
2
/2
(/2)
e
x/2
x
v/21
.
In many cases, 4/
2
2, so the term x
/21
, presenting a mass at zero.
For the square-root process, we already know that conditional on V (s), there is
V (t) F

2(x/c; d, nV (s)),
or
P(V (t) < x | V (s)) = F

2
_
x
c
; d, nV (s)
_
.
where
d =
4

2
n =
4e
(ts)

2
(1 e
(ts)
)
c =
e
(ts)
n
=

2
(1 e
(ts)
)
4
By straightforward calculations, we obtain
E[V (t)| V (s)] = + (V (s) )e
k(ts)
V ar[V (t)| V (s)] = V (s)

e
(ts)
_
1 e
(ts)

+

2

2
_
1 e
(ts)

.
Andersen (2007) proposed a two-segment approximation for non-central chi-square dis-
tribution, called QE (quadratic-exponential) scheme.
For the segment of large value of V (t), V (t) > g,
V (t + t) =

V (t + t) = a(b +

Z)
2
where

Z is a standard Gaussian variable. In fact,

V (t + t) F

2(x/a; 1, b
2
).
22 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
It follows that
E[

V (t + t)] = a(1 + b
2
)
V ar[

V (t + t)] = 2a
2
(1 + 2b
2
),
a and b are chosen such that
a(1 + b
2
) = E[V (t + t)]
2a
2
(1 + 2b
2
) = V ar[V (t + t)].
Denote
=
E[V (t + t)]
2
V ar
2
[V (t + t)]
and assume 1/2, then
a =
E[V (t + t)]
(1 + b
2
)
b = 2 1 +
_
2
_
2 1.
For segment of small V (t), V (t) < g, Andersen proposed the density function
P(

V (t) [x, x + dx]) = [p(x) + q(1 p)e

qx
]dx, x 0
where () is a Dirac delta function and 0 p 1, q 0. By integration, we obtain
F(x) = P(

V (x) < x) = p + (1 p)(1 e

qx
), x 0.
It is easy to obtain
E[

V (t + t)] = (1 p)/q
V ar[

V (t + t)] = (1 p
2
)/q
2
.
To solve for p and q, we set
1 p
q
= E[V (t + t)]
1 p
2
q
2
= V ar[V (t + t)].
Then,
p =
1
1 +
, q =
1 p
E[V (t + t)]
.
We next assume 1.
QE algorithm:
4.4. SIMULATION METHODS WITH THE HESTONS MODEL 23
1. Given V (t), compute E[V (t + t)], V ar[V (t + t)] and .
2. Draw u Uni(0, 1).
3. If g,
(a) Compute a and b
(b) Compute

Z = N
1
(u)
(c) V (t + t) = a(b +

Z)
2
4. If < g,
(a) Compute p and q
(b) Compute V (t + t) = F
1
(u; p, q) for small V (t + t).
It is found that g = 2/3 is a good choice. Moreover,
F
1
(u; p, q) =
_
_
_
0, 0 u p,
q
1
ln
_
1 p
1 u
_
, p u 1.
Example: Andersen (2007)
24 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
4.5 Multi-Factor Extension of the Hestons Model
It is well known that the impplied volatility surface varies stochastically in level, slope and
curvature. The smiles/skews of short-term and long terms options often dier in these three
aspects. To better capture the dynamics of the implied volatility surface, Fonseca et al.
(2008) and Christoersen et al (2009) extend the Hestons 1993 model to a multi-factor
setting. We start with a exposition with a two-factor model for a forward price, F:
dF = F(
_
V
1
dW
1
(t) +
_
V
2
dW
2
(t))
dV
1
= (a
1
b
1
V
1
)dt +
1
_
V
1
dZ
1
(t)
dV
2
= (a
2
b
2
V
2
)dt +
2
_
V
2
dZ
2
(t)
where
dW
1
dZ
1
(t) =
1
dt, dW
2
dZ
2
=
2
dt,
and the correlations for any other pairs are zero. Note that
V ar[dF/F] = (V
1
+ V
2
)dt

= V dt.
Let x = ln F. The moment generating function is
E
t
[exp(ux
T
)] = f(V
1
, V
2
, , u)
where, let = T t,
f(V
1
, V
2
, , u) = exp(A(, u) + B
1
(, u)V
1
+ B
2
(, u)V
2
),
A(, u) =
a
1

2
1
_
(b
1

1
u + d
1
) 2 ln
_
1 g
1
e
d
1

1 g
1
__
+
a
2

2
2
_
(b
2

2
u + d
2
) 2 ln
_
1 g
2
e
d
2

1 g
2
__
B
j
(, u) =
b
j

j
u + d
j

2
j
_
1 e
d
j

1 g
j
e
d
j

_
g
j
=
b
j

j
u + d
j
b
j

j
u d
j
d
j
=
_
(
j

j
u b
j
)
2
+
2
j
(u u
2
)
So, options can be priced using inverse Laplace transform.
At this stage, generalization can becomes trivial. Consider the model
dF = F
n

i=1
_
V
i
dW
i
dV
i
= (a
i
b
i
V
i
)dt +
i
dZ
i
, i = 1, , n
4.5. MULTI-FACTOR EXTENSION OF THE HESTONS MODEL 25
with
dW
i
dZ
j
=
ij

i
dt, dW
i
dW
j
= dZ
i
dZ
j
= 0.
Note that we can let some
i
= 0 to reduce the no. of stochastic factor.
General solution for CF
E
t
[exp(ux
T
)] = f({V
i
}, , u) = exp
_
A(, u) +
n

i=1
B
i
(, u)V
i
_
A(, u) =
n

i=1
a
i

2
i
_
(b
i

i
u + d
i
) 2 ln
_
1 g
i
e
d
i

1 g
i
__
B
j
(, u) =
b
j

j
u + d
j

2
j
_
1 e
d
j

1 g
j
e
d
j

_
g
j
=
b
j

j
u + d
j
b
j

j
u d
j
d
j
=
_
(
j

j
u b
j
)
2
+
2
j
(u u
2
)
The multi-factor model has bigger capacity to capture the price dynamics and does more
accurate pricing. However, the calibration of the model will only be more dicult.
26 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
4.6 Stochastic Alpha, Beta and Rho Model
Once the local-volatility (LV) models are determined by calibration, it is a single, self-
consistent model which correctly reproduces the market prices of calls (and puts) for all
strikes K and exercise dates. These models yield consistent delta and vega risks for all op-
tions, so these risks can be consolidated across strikes. However, the LV model predicts the
wrong dynamics of the IV curve, which leads to a inaccurate and often unstable hedges. The
following analysis was done by Hagan, Kumar, Lesnieski, and Woodward (2002). Let F be
the forward price of an asset. Then, an LV model can be cast as
dF =
loc
(F)FdW, F(0) = f
Using the singular perturbation methods, the IV of the European call and put by Blacks
formula is given by

B
(K, f) =
loc
_
1
2
[f + K]
_
1 +
1
24

loc
_
1
2
[f + K]
_

loc
_
1
2
[f + K]
_(f K)
2
+
__
Suppose that todays IV is

0
B
(K) = + [K f
0
]
2
,
as is displayed in Figure ?
As the forward price f evolves away from f
0
, the IV is predicted as

B
(K, f) = +
_
K
_
3
2
f
0

1
2
f
__
2
+
3
4
(f f
0
)
2
+
In real markets, the IV moves in the opposite direction as the direction predicted by the
model. In other words, the correction term needed for real markets should have opposite
4.6. STOCHASTIC ALPHA, BETA AND RHO MODEL 27
sign as the correction predicted by the LV model.
The value of a call option given by the Blacks formula
V
call
= BS(f, K,
B
(K, f), t
ex
)
Delta risk is thus given by

V
call
f
=
BS
f
+
BS

B
(K, f)
f
The rst term is the delta risk from Blacks model using the IV from the market. The
second term is the LV models correction to the delta risk, which consists of the Black vega
risk multiplied by the predicted change in
B
w.r.t. the underlying forward price f. The
consequence is that the original Black model yields more accurate hedges than the LV model,
even though the LV model is self-consistent across strikes and Blacks model is inconsistent.
28 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
The failure of LV models suggests that a Markovian model based on a single Brownian
motion cannot manage smile risks well. Hagan, Kumar, Lesnieski, and Woodward (2002)
propose a simple SV model called SABR model (stochasti model) for correctly cap-
turing/predicting smile dynamics. This model is in terms of the forward price and takes the
form
dF(t) = V (t)F

(t)dW
t
, F(0) = f, (4.6.15)
dV (t) = V (t)dZ
t
, V (0) = , (4.6.16)
where
dW
t
dZ
t
= dt,
0 < < 1, , > 0, and || 1. Note that the volatility is not mean reverting, which may
undermine the ability of the model to price big maturity options.
A distinguished advantage of the model is its analytical tractability for option pricing.
More precisely, the price of European options can be obtained analytically in the Blacks
formula, with the Blacks implied volatility given by

imp
(K, f, T) =

(fK)
1
2
_
1 +
(1)
2
24
ln
2
_
f
K
_
+
(1)
4
1920
ln
4
_
f
K
_
_ (4.6.17)

z
x(z)
_
1 +
_
(1 )
2

2
24(fK)
1
+

4(fK)
1
2
+
2
2 3
2
24
__
(4.6.18)
where
z =

(fK)
1
2
ln
_
f
K
_
x(z) = ln
_
_
1 2z + z
2
+ z
1
_
This formula is quite robust.
Several remarks are in order.
1. The SABR model can be used to accurately t the IV curves observed in the market
for any single exercise date
2. It is an eective mean to manage the smile risk in markets where each asset has only
a single exercise date (e.g. swaptions and caplet / oorlet)
3. In the IR market, vega risk can be hedged by buying / selling other options on the
asset
Interpretation of parameters
4.6. STOCHASTIC ALPHA, BETA AND RHO MODEL 29
1. The parameter
controls the backbone.
With any specic choice of , market smiles can generally be t more or less
equally well.
can be determined from the historical observations of the backbone.
The curve that the ATM IV
B
(f, f) traces is known as backbone.
is estimated from a log-log plot of
B
(f, f).
= 0 is essential for JPY IR market.
= 1/2 are usually USD IR market (CIR model).
Fig.1. Consumer Price Indexes of United States and Euro zone
2. The parameter
is calibrated to the level of ATM volatility (K = f)

ATM
=
B
(f, f) =

f
1
_
1 +
_
(1 )
2
24

2
f
2(1)
+
1
4

f
1
+
2 3
2
24

2
_
T +
_
It is usually convenient to use
ATM
to replace in the parameter set.
3. The parameter and
controls the smile and skew
controls the curvature of the smile / skew
The vol of vol is very big for short-dated options, and decreases as the time-
to-exercise increases; where starts near zero and becomes substantially negative.
Frequency of parameter tting
Typically, or
ATM
are updated daily or every few hours.
30 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
and are re-tted every month or as needed.
does not change at all.
For swaptions in the IR market
There is a weak dependence of the market skew / smile on the length of the
underlying swaps.
Both and are fairly constant for each tenor (for xed maturity).
We have the following additional remarks on the performance of the model.
1. In most market, there is a strong smile for short-dated options which relaxes as the
time-to-expiry increases.
4.6. STOCHASTIC ALPHA, BETA AND RHO MODEL 31
2. Consequently, the vol of vol is large for short-dated options and smaller for long-dated
options, regardless of the particular underlying.
3. Correlation results is less clear: in some market a nearly at skew for short-dated
options develops into a strongly downward sloping skew for longer expiries.
4. In other market, a strongly downward skew for all options maturities, and in other
markets, the skew is close to zero for all maturities.
More on hedging under the SABR model.
- The value of a call is
V
call
= BS(f, K,
B
(K, f), t
ex
)
- The vega risk is given by
V
call

=
BS

+
BS

B
(K, f; , , , )

- It is traditional to scale vega so that it represents the change in value when the ATM
volatility changes by a unit amount.
- Taking the leading order terms, it yields
vega
BS

B
(K, f)

ATM
(f)
=
BS

B
(K, f)

B
(f, f)
- Vega risk at dierent strikes are calculated by bumping the IV at each strike K by
an amount that is proportional to the IV,
B
(K, f), at that strike (as shown in the
previous slide).
- This is not a parallel but a proportional shift of the volatility curve to calculate the
total vega risk of a book of options.
- Similarly, vanna is the risk associated with the change in and volga (vol gamma) is
the risk associated with the change in :
vanna =
V
call

=
BS

B
(K, f; , , , )

volga =
V
call

=
BS

B
(K, f; , , , )

- Vanna expresses the risk to the skew increasing, and the volga expresses the risk to the
smile becoming more pronounced.
32 CHAPTER 4. STOCHASTIC VOLATILITY MODELS
- The delta risk expressed by the SABR model depends on the parameter set: , ,
and .
- This is not a parallel but a proportional shift of the volatility curve to calculate the
total vega risk of a book of options.
- This predicted change provides a sideways movement of the volatility curve in the same
direction (and the same amount) as the change in the forward price f.
- The delta is calculated by

V
call
f
=
BS
f
+
BS

B
(K, f; , , , )
f
- The rst term is the ordinary delta risk that can be calculated from the Blacks model.
- The second term is the SABR models correction to the delta risk: Black vega risk times
the predicted change in the IV caused by the change in the forward f.
- To proceed risk management for a book of options, one must bump each parameter in
turn, and re-valuing the book yields
A matrix of , risks (vega).
A matrix of risks (vanna).
A matrix of risk (volga).
Soon after its publication in 2002, the SABR model quickly has gained popularity in
various derivatives markets, including
Equity option smiles
xed-income option smiles
ination option smiles
From both theoretical and practical point of view, the SABR model still has serious
limitations.
There is mean reversion in the dynamics of stochastic dynamics, making the pricing of
options with big maturities unreliable.
SABR is not a term structure model. Additional assumptions are needed for pricing
options depending on multiple points of the term structure, e.g., spread options on
CMS rates.
SABR does not have enough control on the shape of the volatility curve so that it
cannot apply to markets with very dierent phenomenon.