Option Pricing with Mean Reversion and Stochastic Volatility

Download or read book Option Pricing with Mean Reversion and Stochastic Volatility written by Hoi Ying Wong and published by . This book was released on 2009 with total page 25 pages. Available in PDF, EPUB and Kindle. Book excerpt: Many underlying assets of option contracts, such as currencies, commodities, energy, temperature and even some stocks, exhibit both mean reversion and stochastic volatility. This paper investigates the valuation of options when the underlying asset follows a mean-reverting lognormal process with stochastic volatility. A closed-form solution is derived for European options by means of Fourier transform. The proposed model allows the option pricing formula to capture both the term structure of futures prices and the market implied volatility smile within a unified framework. A bivariate trinomial lattice approach is introduced to value path-dependent options with the proposed model. Numerical examples using European options, American options and barrier options demonstrate the use of the model and the quality of the numerical scheme.