Miri

Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Time dependent Heston model

Mohammed Miri (Pricing Partners and LJK)
joint work with
Eric Benhamou (Pricing Partners)
and Emmanuel Gobet (LJK)
Paper available on ssrn.com.
Numerical Methods in Finance
Paris, 15-17 April 2009
Summary
Introduction
Framework
Fourier Inversion
Review of Analytical approximations
Motivation
Smart Taylor Expansion
Smart parameterization
Correction terms estimation
Errors analysis
Numerical results
Conclusion
Bibliography
Summary
Introduction
Framework
Fourier Inversion
Motivation
Errors analysis
Numerical results
Conclusion
Bibliography
Framework
Heston model
the Heston model is an extension of Black Scholes model with
stochastic volatility:
dX
t
=
v
t
dW
t
v
t
2
dt, X
0
= x
0
, (1)
dv
t
= (
t
v
t
)dt +
t
v
t
dB
t
, v
0
, (2)
dW, B
t
=
t
dt,
where
v
0
the initial square of volatility.
is the mean reversion parameter.
the long-term level.
the vol of vol.
the correlation.
Fourier Inversion
Fourier inversion
The call price for Heston model can be written using Lewis
formula:
Call
Heston
(t, S
t
, v
t
; T, K) =S
t
e
_
T
t
q
s
ds
Ke
_
T
t
r
s
ds
2
_ i
2
+
i
2
e
izX
T
(z)
dz
z
2
iz
where X = log
_
S
t
e
_
T
t
q
s
ds
Ke
_
T
t
r
s
ds
_
and
T
(z) = E(e
z(X
T
X
t
)
|F
t
)
Explicit computation of this integral requires explicit

computation of the characteristic function:
T
(z) = E(e
z(X
T
X
t
)
|F
t
).
Fourier Inversion
Fourier inversion
The call price for Heston model can be written using Lewis
formula:
Call
Heston
(t, S
t
, v
t
; T, K) =S
t
e
_
T
t
q
s
ds
Ke
_
T
t
r
s
ds
2
_ i
2
+
i
2
e
izX
T
(z)
dz
z
2
iz
where X = log
_
S
t
e
_
T
t
q
s
ds
Ke
_
T
t
r
s
ds
_
and
T
(z) = E(e
z(X
T
X
t
)
|F
t
)
Explicit computation of this integral requires explicit

computation of the characteristic function:
T
(z) = E(e
z(X
T
X
t
)
|F
t
).
Fourier Inversion
Characteristic Function: case of constant parameters
The characteristic function
T
(z) = E(e
z(X
T
X
t
)
|F
t
) is explicit
when the parameters , and are constant.
PDE approach: The Heston model belongs to afne

models and they have explicit characteristic function solved
using PDE argument and Riccatti equations (Heston 93).
Probabilist approach: The CIR process v is a time space

changed Bessel process (Going-Jaeschke and Yor 03).
To avoid discontinuities due to complex integration we refer to
the work of Jackel and Kahl 05.
Fourier Inversion
T
(z) = E(e
z(X
T
X
t
)
|F
t
) is explicit


Fourier Inversion
T
(z) = E(e
z(X
T
X
t
)
|F
t
) is explicit


Fourier Inversion
T
(z) = E(e
z(X
T
X
t
)
|F
t
) is explicit


Fourier Inversion
Characteristic Function: case of piecewise constant
parameters
T
(z) = E(e
z(X
T
X
t
)
|F
t
) is
computed recursively when the parameters , and are
piecewise constant.
PDE approach: The characteristic function

T
(z) can be
computed recursively using nested Riccatti equations with
constant coefcients (Mikhailov et al 03).
Probabilist approach: We use a Markov argument in order

to compute recursively the characteristic function (Elices
08).
Fourier Inversion
parameters
T
(z) = E(e
z(X
T
X
t
)
|F
t
) is
piecewise constant.

T
(z) can be

08).
Fourier Inversion
parameters
T
(z) = E(e
z(X
T
X
t
)
|F
t
) is
piecewise constant.

T
(z) can be

08).
Long maturity
Ergodic approach (Fouque et al 00): the volatility is fast

mean reverting. Perturbation of the innitesimal generator.
L
=
1
L
(0)
+
1
L
(1)
+ L
(2)
,
=Call = Call
(0)
BS
+
Correction
(1)
+
Expression of the price as a Black Scholes price plus

some Greeks. Error bounds are available.
Accurate only for long maturities and for time

homogeneous parameters.
Short maturity
Geodesic approach (Berestycki et al 04, Labordere 05,

Forde 08,...): asymptotic expansion of the implied volatility
near expiry.
In all these works, the related geodesic distance for

constant Hestons model is not explicit. However, it can be
approximated using series expansion (Lewis 07).
Accurate only for short maturities and for time

homogeneous parameters.
Others
Averaging techniques (Piterbarg 05): Averaged constant

Heston parameters are derived for Call price in Time
dependent Heston model. Accurate only for zero
correlation.
Price expansion w.r.t. correlation (Antonelli and

Scarlatti 09). Error bounds are available. Accurate only for
time homogeneous parameters.
Motivation
Challenge
Give an accurate analytic approximation for the price of

Call-Put option in general time dependent Heston
e
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] (3)
with computational time cheaper than Fourier inversion

(gain by a factor 100 or more).
Motivation
Challenge

e
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] (3)

Motivation
Challenge

e
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] (3)

Summary
Introduction
Framework
Fourier Inversion
Motivation
Errors analysis
Numerical results
Conclusion
Bibliography
Our approach: Proxy model
Our approach is based on small volatility of volatility

expansion .
The proxy model is the Heston model without volatility of

volatility. Therefore, The proxy is a BS model with
deterministic volatility v
0,t
.
dX
BS
t
=

v
0,t
dW
t
v
0,t
2
dt, X
BS
0
= x
0
,
dv
0,t
= (
t
v
0,t
)dt, v
0
.

expansion .

0,t
.
dX
BS
t
=

v
0,t
dW
t
v
0,t
2
dt, X
BS
0
= x
0
,
dv
0,t
= (
t
v
0,t
)dt, v
0
.

expansion .

0,t
.
dX
BS
t
=

v
0,t
dW
t
v
0,t
2
dt, X
BS
0
= x
0
,
dv
0,t
= (
t
v
0,t
)dt, v
0
.
Our approach: Proxy price
In this case the put price is P
BS
(x
0
,
_
T
0
v
0,t
dt)
where the function (x, y) P

BS
(x, y) is the put function price
in a BS model with spot e
x
, strike K, total variance y,
risk-free rate r
eq
=
_
T
0
r(t)dt
T
, dividend yield q
eq
=
_
T
0
q(t)dt
T
and
maturity T.
we recall that P
BS
(x, y) has the following explicit expression:
P
BS
(x, y) =Ke
r
eq
T
N
_
1
y
log(
Ke
r
eq
T
e
x
e
q
eq
T
) +
1
2
y
_
e
x
e
q
eq
T
N
_
1
y
log(
Ke
r
eq
T
e
x
e
q
eq
T
)
1
2
y
_
.
Our approach: Proxy price
In this case the put price is P
BS
(x
0
,
_
T
0
v
0,t
dt)
where the function (x, y) P

BS
(x, y) is the put function price
in a BS model with spot e
x
, strike K, total variance y,
risk-free rate r
eq
=
_
T
0
r(t)dt
T
, dividend yield q
eq
=
_
T
0
q(t)dt
T
and
maturity T.
we recall that P
BS
(x, y) has the following explicit expression:
P
BS
(x, y) =Ke
r
eq
T
N
_
1
y
log(
Ke
r
eq
T
e
x
e
q
eq
T
) +
1
2
y
_
e
x
e
q
eq
T
N
_
1
y
log(
Ke
r
eq
T
e
x
e
q
eq
T
)
1
2
y
_
.
How to measure errors between the model and its
proxy
Suitable parameterization
dv
t
= (
t
v
t
)dt +
t
_
v
t
dB
t
,
so that v
1
t
= v
t
and v
0
t
= v
0,t
.
Expansion w.r.t. for = 1 around = 0:
v
t
= v
0,t
.,.
the deterministic volatility
+
(v
t
)
|
=0
+
2
(v
t
)
2
|
=0
+
Question: How to estimate the derivatives
(v
t
)
|
=0
,

2
(v
t
)
2
|
=0
?
They are null when is null.
(v
t
)
|
=0
= e
t
_
t
0
e
s
v
0,s
dB
s
.
(v
t
)
|
=0
is of the order of ||
.
proxy
dv
t
= (
t
v
t
)dt +
t
_
v
t
dB
t
,
so that v
1
t
= v
t
and v
0
t
= v
0,t
.
v
t
= v
0,t
.,.
+
(v
t
)
|
=0
+
2
(v
t
)
2
|
=0
+
(v
t
)
|
=0
,

2
(v
t
)
2
|
=0
?
(v
t
)
|
=0
= e
t
_
t
0
e
s
v
0,s
dB
s
.
(v
t
)
|
=0
.
proxy
dv
t
= (
t
v
t
)dt +
t
_
v
t
dB
t
,
so that v
1
t
= v
t
and v
0
t
= v
0,t
.
v
t
= v
0,t
.,.
+
(v
t
)
|
=0
+
2
(v
t
)
2
|
=0
+
(v
t
)
|
=0
,

2
(v
t
)
2
|
=0
?
(v
t
)
|
=0
= e
t
_
t
0
e
s
v
0,s
dB
s
.
(v
t
)
|
=0
.
Heston price= expectation of stochastic BS price
X
T
= x
0
+
_
T
0
(
v
t
dW
t
v
t
2
dt) conditioned on the ltration
(F
B
t
)
t
generated by the Brownian motion B is:
a Gaussian distribution with mean
x
0
+
_
T
0

t
v
t
dB
t
1
2
_
T
0
v
t
dt and variance
_
T
0
(1
2
t
)v
t
dt
(Renault and Touzi 96).
So, the Put price e
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] is an
expectation of a stochastic Black Scholes Put price:
E[P
BS
(x
0
+
_
T
0
v
t
dB
t
_
T
0
2
t
2
v
t
dt,
_
T
0
(1
2
t
)v
t
dt)].
X
T
= x
0
+
_
T
0
(
v
t
dW
t
v
t
2
(F
B
t
)
t
x
0
+
_
T
0

t
v
t
dB
t
1
2
_
T
0
v
t
dt and variance
_
T
0
(1
2
t
)v
t
dt
So, the Put price e
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] is an
E[P
BS
(x
0
+
_
T
0
v
t
dB
t
_
T
0
2
t
2
v
t
dt,
_
T
0
(1
2
t
)v
t
dt)].
X
T
= x
0
+
_
T
0
(
v
t
dW
t
v
t
2
(F
B
t
)
t
x
0
+
_
T
0

t
v
t
dB
t
1
2
_
T
0
v
t
dt and variance
_
T
0
(1
2
t
)v
t
dt
So, the Put price e
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] is an
E[P
BS
(x
0
+
_
T
0
v
t
dB
t
_
T
0
2
t
2
v
t
dt,
_
T
0
(1
2
t
)v
t
dt)].
Taylor expansion of the price
By performing a Taylor expansion for the P
BS
function at the
second order around
(x
0
+
_
T
0

t
v
0,t
dB
t
_
T
0
2
t
2
v
0,t
dt,
_
T
0
(1
2
t
)v
0,t
dt), we obtain
e
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] = P
BS
(x
0
,
_
T
0
v
0,t
dt)
+ Correction terms + Errors.
Estimation of corrections terms
Theorem
The correction terms are a linear combination of Greeks of the
proxy Black Scholes Model:
Correction terms =
2
i=1
a
i,T
i+1
P
BS
x
i
y
(x
0
,
_
T
0
v
0,t
dt)
+
1
i=0
b
2i,T
2i+2
P
BS
x
2i
y
2
(x
0
,
_
T
0
v
0,t
dt),
where
a
1,T
=
_
T
0
_
T
t
1
e
t
1
t
1
t
1
v
0,t
1
e
t
2
dt
1
dt
2
,
a
2,T
=
_
T
0
_
T
t
1
_
T
t
2
e
t
1
t
1
t
1
v
0,t
1
t
2
t
2
e
t
3
dt
1
dt
2
dt
3
,
b
0,T
=
_
T
0
_
T
t
1
_
T
t
2
e
2t
1
2
t
1
v
0,t
1
e
t
2
e
t
3
dt
1
dt
2
dt
3
,
b
2,T
=
a
2
1,T
2
.
The proof relies on (heavy) Malliavin calculus techniques.

where
a
1,T
=
_
T
0
_
T
t
1
e
t
1
t
1
t
1
v
0,t
1
e
t
2
dt
1
dt
2
,
a
2,T
=
_
T
0
_
T
t
1
_
T
t
2
e
t
1
t
1
t
1
v
0,t
1
t
2
t
2
e
t
3
dt
1
dt
2
dt
3
,
b
0,T
=
_
T
0
_
T
t
1
_
T
t
2
e
2t
1
2
t
1
v
0,t
1
e
t
2
e
t
3
dt
1
dt
2
dt
3
,
b
2,T
=
a
2
1,T
2
.
The proof relies on (heavy) Malliavin calculus techniques.

In case of the Heston model with constant parameters, one has:
a
1,T
=(p
0
v
0
+ p
1
),
a
2,T
=()
2
(q
0
v
0
+ q
1
), b
0,T
=
2
(r
0
v
0
+ r
1
).
where
p
0
=
e
T
_
T + e
T
1
_
2
, p
1
=
e
T
_
T + e
T
(T 2) + 2
_
2
,
q
0
=
e
T
_
T(T + 2) + 2e
T
2
_
2
3
,
q
1
=
e
T
_
2e
T
(T 3) + T(T + 4) + 6
_
2
3
,
r
0
=
e
2T
_
4e
T
T + 2e
2T
2
_
4
3
,
r
1
=
e
2T
_
4e
T
(T + 1) + e
2T
(2T 5) + 1
_
4
3
.
In case of Heston model with piecewise constant

parameters, we use recursive calculus for the coefcients
a
1,T
, a
2,T
, b
0,T
.
Averaged parameters are derived from the approximation.
For more details about these aspects

see Benhamou, Gobet and Miri 09.

a
1,T
, a
2,T
, b
0,T
.


a
1,T
, a
2,T
, b
0,T
.

Errors analysis
Errors analysis
Theorem
The residual errors of the approximation formula are:
Errors = O(||
3
T
2
).
Proof relies on (heavy) technical Lemmas.
Summary
Introduction
Framework
Fourier Inversion
Motivation
Errors analysis
Numerical results
Conclusion
Bibliography
Approximation accuracy: Strikes
Table: Set of maturities and strikes used for the numerical tests.
T/K
3M 70 80 90 100 110 120 125 130
6M 60 70 80 100 110 130 140 150
1Y 50 60 80 100 120 150 170 180
2Y 40 50 70 100 130 180 210 240
3Y 30 40 60 100 140 200 250 290
5Y 20 30 60 100 150 250 320 400
7Y 10 30 50 100 170 300 410 520
10Y 10 20 50 100 190 370 550 730
Approximation accuracy for Constant Heston model
Approximation accuracy for Piecewise Heston model
Computational time: Gain by a factor of 100 or more
Table: Computational time for our approximation formula against
Fourier inversion.
Method Constant parameters
(ms)
Piecewise Constant pa-
rameters (ms)
Approximation
formula
0.018 0.138
Fourier 4.708 40.225
Gain 261 291
Summary
Introduction
Framework
Fourier Inversion
Motivation
Errors analysis
Numerical results
Conclusion
Bibliography
Conclusion
The challenge is over:
The accuracy of our approximation turns out to be

excellent; the errors do not exceed few bps for various
strikes and maturities.
The accuracy of our averaging formula is extremely

accurate.
The computational cost is cheaper than Fourier inversion

(gain by factor of 100 or more).
Summary
Introduction
Framework
Fourier Inversion
Motivation
Errors analysis
Numerical results
Conclusion
Bibliography
Bibliography
F. Antonelli and S. Scarlatti. Pricing options under stochastic
volatility: a power series approach. Finance and Stochastics,
2009
E. Benhamou, E. Gobet, and M. Miri. Time dependent Heston
model. available on ssrn, submitted, 2009.
A. Elices. Models with time-dependent parameters using
transform methods: application to Heston s model. 2008.
M. Forde. The small-time behavior of diffusion and
time-changed diffusion processes on the line. , 2008.
J.P. Fouque, G. Papanicalaou, and R. Sircar. Derivatives in
nancial Markets with stochastic volatility. Cambridge
University Press, 2000.
Bibliography
A. Going-Jaeschke and M. Yor. A survey and some
generalizations of Bessel processes. Bernoulli, 2003.
P. Jackel and C. Kahl. Not-So-Complex Logarithms in
theHestonModel. WilmottMagazine, September 2005.
S. Heston. A closed-form solutions for options with stochastic
volatility with applications to bond and currency options,.
Review of Financial Studies, 1993.
A. Lewis. Geometries and smile asymptotics for a class of
stochastic volatility models. www.optioncity.net, 2007.
A. Lewis. Option valuation under stochastic volatility with
Mathematica code. Finance Press, Newport Beach, California,
2000.
V.V. Piterbarg. Time to smile. Risk Magazine, 2005.
Thank you for your
attention!

Miri

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Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography

Time dependent Heston model

is the mean reversion parameter.

the long-term level.

the vol of vol.

Explicit computation of this integral requires explicit

Explicit computation of this integral requires explicit

PDE approach: The Heston model belongs to afne

Probabilist approach: The CIR process v is a time space

PDE approach: The Heston model belongs to afne

Probabilist approach: The CIR process v is a time space

PDE approach: The Heston model belongs to afne

Probabilist approach: The CIR process v is a time space

PDE approach: The Heston model belongs to afne

Probabilist approach: The CIR process v is a time space

PDE approach: The characteristic function

Probabilist approach: We use a Markov argument in order

PDE approach: The characteristic function

Probabilist approach: We use a Markov argument in order

PDE approach: The characteristic function

Probabilist approach: We use a Markov argument in order

Ergodic approach (Fouque et al 00): the volatility is fast

Expression of the price as a Black Scholes price plus

Accurate only for long maturities and for time

Geodesic approach (Berestycki et al 04, Labordere 05,

In all these works, the related geodesic distance for

Accurate only for short maturities and for time

Averaging techniques (Piterbarg 05): Averaged constant

Price expansion w.r.t. correlation (Antonelli and

Give an accurate analytic approximation for the price of

with computational time cheaper than Fourier inversion

Give an accurate analytic approximation for the price of

with computational time cheaper than Fourier inversion

Give an accurate analytic approximation for the price of

with computational time cheaper than Fourier inversion

Our approach is based on small volatility of volatility

The proxy model is the Heston model without volatility of

Our approach is based on small volatility of volatility

The proxy model is the Heston model without volatility of

Our approach is based on small volatility of volatility

The proxy model is the Heston model without volatility of

where the function (x, y) P

where the function (x, y) P

They are null when is null.

They are null when is null.

They are null when is null.

So, the Put price e

So, the Put price e

So, the Put price e

The proof relies on (heavy) Malliavin calculus techniques.

The proof relies on (heavy) Malliavin calculus techniques.

In case of Heston model with piecewise constant

Averaged parameters are derived from the approximation.

For more details about these aspects

In case of Heston model with piecewise constant

Averaged parameters are derived from the approximation.

For more details about these aspects

In case of Heston model with piecewise constant

Averaged parameters are derived from the approximation.

For more details about these aspects

The accuracy of our approximation turns out to be

The accuracy of our averaging formula is extremely

The computational cost is cheaper than Fourier inversion

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