Simplied Derivation of the Heston Model

by Fabrice Douglas Rouah

www.FRouah.com
www.Volopta.com
Note: A complete treatment of the Heston model, including a
more detailed derivation of what appears below, is available in the
forthcoming book "The Heston Model and its Extensions in Matlab
and C#", available September 3, 2013 from John Wiley & Sons. The
table of contents is available at www.FRouah.com.
The stochastic volatility model of Heston [2] is one of the most popular
equity option pricing models. This is due in part to the fact that the Heston
model produces call prices that are in closed form, up to an integral that must
evaluated numerically. In this Note we present a complete derivation of the
Heston model.
1 Heston Dynamics
The Heston model assumes that the underlying, o
|
, follows a Black-Scholes
type stochastic process, but with a stochastic variance
|
that follows a Cox,
Ingersoll, Ross process. Hence
do
|
= ro
|
dt +
p

|
o
|
d\
1,|
(1)
d
|
= i(0
|
)dt +o
p

|
d\
2,|
1 [d\
1,|
d\
2,|
] = jdt.
We will drop the time index and write o = o
|
, =
|
, \
1
= \
1,|
, and \
2
= \
1,|
for notional convenience.
2 The Heston PDE
In this section we explain how to derive the PDE from the Heston model. This
derivation is a special case of a PDE for general stochastic volatility models
which is described by Gatheral [1]. Form a portfolio consisting of one option
\ = \ (o, , t), units of the stock o, and c units of another option l =
l(o, , t) that is used to hedge the volatility. The portfolio has value
= \ + o +cl
where =
|
. Assuming the portfolio is self-nancing, the change in portfolio
value is
d = d\ + do +cdl.
1
2.1 Portfolio Dynamics
Apply Itos Lemma to d\ . We must dierentiate with respect to the variables
t, o, and . Hence
d\ =
0\
0t
dt +
0\
0o
do +
0\
0
d +
1
2
o
2
0
2
\
0o
2
dt +
1
2
o
2

0
2
\
0
2
dt +ojo
0
2
\
00o
dt.
Applying Itos Lemma to dl produces the identical result, but in l. Combining
these two expressions, we can write the change in portfolio value, d, as
d = d\ + do +cdl (2)
=
_
0\
0t
+
1
2
o
2
0
2
\
0o
2
+joo
0
2
\
00o
+
1
2
o
2

0
2
\
0
2
_
dt +
c
_
0l
0t
+
1
2
o
2
0
2
l
0o
2
+joo
0
2
l
00o
+
1
2
o
2

0
2
l
0
2
_
dt +
_
0\
0o
+c
0l
0o
+
_
do +
_
0\
0
+c
0l
0
_
d.
2.2 The Riskless Portfolio
In order for the portfolio to be hedged against movements in the stock and
against volatility, the last two terms in Equation (2) involving do and d must
be zero. This implies that the hedge parameters must be
c =
J\
Ju
JI
Ju
(3)
= c
0l
0o

0\
0o
.
Moreover, the portfolio must earn the risk free rate, r. Hence d = rdt. Now
with the values of c and from Equation (3) the change in value of the riskless
portfolio is
d =
_
0\
0t
+
1
2
o
2
0
2
\
0o
2
+joo
0
2
\
00o
+
1
2
o
2

0
2
\
0
2
_
dt +
c
_
0l
0t
+
1
2
o
2
0
2
l
0o
2
+joo
0
2
l
00o
+
1
2
o
2

0
2
l
0
2
_
dt
which we write as d = (+c1) dt. Hence we have
+c1 = r (\ + o +cl) .
Substituting for c and re-arranging, produces the equality
r\ +ro
J\
JS
J\
Ju
=
1 rl +ro
JI
JS
JI
Ju
(4)
which we exploit in the next section.
2
2.3 The PDE in Terms of the Price
The left-hand side of Equation (4) is a function of \ only, and the right-hand
side is a function of l only. This implies that both sides can be written as
a function )(o, , t) of o, , and t. Following Heston, specify this function as
)(o, , t) = i(0 ) +`(o, , t), where `(o, , t) is the price of volatility risk.
Substitute )(o, , t) into the left-hand side of Equation (4), substitute for 1,
and rearrange to produce the Heston PDE expressed in terms of the price o
0l
0t
+
1
2
o
2
0
2
l
0o
2
+joo
0
2
l
00o
+
1
2
o
2

0
2
l
0
2
(5)
rl +ro
0l
0o
+ [i(0 ) `(o, , t)]
0l
0
= 0.
This is Equation (6) of Heston [2].
2.4 The PDE in Terms of the Log Price
Let r = lno and express the PDE in terms of r, t and instead of o, t, and .
This leads to a simpler form of the PDE. We need the following derivatives,
which are straightforward to derive
0l
0o
,
0
2
l
00o
,
0
2
l
0o
2
Plug into the Heston PDE Equation (5). All the o terms cancel and we obtain
the Heston PDE in terms of the log price r = lno
0l
0t
+
1
2

0
2
l
0r
2
+
_
r
1
2

_
0l
0r
+jo
0
2
l
00r
+ (6)
1
2
o
2

0
2
l
0
2
rl + [i(0 ) `]
0l
0
= 0
where, as in Heston, we have written the market price of risk to be a linear
function of the volatility, so that `(o, , t) = `.
3 The Call Price
The call price is of the form
C
T
(1) = c
:r
1
_
(o
T
1)
+
_
(7)
= c
rt
1
1
(r, , t) c
:r
11
2
(r, , t).
In this expression 1

(r, , t) each represent the probability of the call expiring

in-the-money, conditional on the value r
|
= lno
|
of the stock and on the value

|
of the volatility at time t, where t = T t is the time to expiration. Now take
the following derivatives of C using (7). These are straightforward to obtain
0C
0t
,
0C
0r
,
0
2
C
0r
2
,
0C
0
,
0
2
C
0
2
,
0
2
C
0r0
.
3
We use these derivatives in the following section.
3.1 The PDE for P
1
and P
2
The call price C in Equation (7) follows the PDE in Equation (6), which we
write here in terms of C but using the time derivative with respect to t rather
than t

0C
0t
+
1
2

0
2
C
0r
2
+
_
r
1
2

_
0C
0r
+jo
0
2
C
00r
+ (8)
1
2
o
2

0
2
C
0
2
rC + [i(0 ) `]
0C
0
= 0.
The derivatives of C from (7) will be in terms of 1
1
and 1
2
. Substitute these
derivatives into the PDE (8) and regroup terms common to 1
1
. Set 1 = 0 and
o = 1 to obtain the PDE for 1
1
. Now regroup terms common to 1
2
and set
o = 0, 1 = 1, and r = 0 to obtain the PDE for 1
2
For notional convenience,
combine the PDEs for 1
1
and 1
2
into a single expression

01

0t
+jo
0
2
1

0r0
+
1
2

0
2
1

0r
2
+
1
2
o
2
0
2
1

0
2
(9)
+(r +n

)
01

0r
+ (a /

)
01

0
= 0
for , = 1, 2 and where n
1
=
1
2
, n
2
=
1
2
, a = i0, /
1
= i+`jo, and /
2
= i+`.
This is Equation (12) of Heston [2] but in terms of t rather than t. That
explains the minus sign in the rst term of Equation (9) above.
3.2 Obtaining the Characteristic Functions
Heston assumes that the characteristic functions for the logarithm of the termi-
nal stock price, r = lno
T
, are of the form
)

(c; r, ) = exp (C

(t, c) +1

(t, c)
0
+icr) (10)
where C

and 1

are coecients and t = T t is the time to maturity. The

characteristic functions )

will follow the PDE in Equation (9). This is a con-

sequence of the Feynman-Kac theorem. Hence the PDE for the characteristic
function is, from Equation (9)

0)

0t
+jo
0
2
)

0r0
+
1
2

0
2
)

0r
2
+
1
2
o
2
0
2
)

0
2
(11)
+(r +n

)
0)

0r
+ (a /

)
0)

0
= 0.
To evaluate this PDE for the characteristic function we need the following deriv-
atives, which are straightforward to derive
0)

0t
,
0)

0r
,
0
2
)

0r
2
,
0)

0
,
0
2
)

0
2
,
0
2
)

00r
.
4
Substitute these derivatives in Equation (11), drop the )

terms, and re-arrange

to obtain two dierential equations
01

0t
= joic1

1
2
c
2
+
1
2
o
2
1
2

+n

ic /

(12)
0C

0t
= ric +a1

.
These are Equations (A7) in Heston [2]. Heston species the initial conditions
1

(0, c) = 0 and C

(0, c) = 0. The rst Equation in (12) is a Riccati equation

in 1

while the second is an ODE for C

that can solved using straightforward

integration once 1

is obtained.
3.3 Solving the Heston Riccati Equation
From Equation (12) the Heston Riccati equation is
01

0t
= 1

+11
2

(13)
The corresponding second order ODE is
n
00
+Q

n
0
+1

1 = 0 (14)
The solution to the Heston Riccati equation (13) is therefore
1

=
1
1
_
1cc
or
+,c
or
1c
or
+c
or
_
(15)
Using the initial condition 1

(0, c) = 0 produces the solution for 1

=
/

joic +d

o
2
_
1 c
Jjr
1 q

c
Jjr
_
. (16)
where
d

=
_
(joic /

)
2
o
2
_
2n

ic c
2
_
.
q

=
/

joic +d

joic d

.
The solution for C

is found by integrating the second equation in (12). Hence

C

=
_
r
0
ricdj +a
_
Q

+d

21
__
r
0
_
1 c
Jj
1 q

c
Jj
_
dj +1
1
(17)
where 1
1
is a constant. Integrate and apply the initial condition C

(0, c) = 0,
and substitute for d

, Q

, and q

to obtain the solution for C

= rict +
a
o
2
_
(/

joic +d

) t 2 ln
_
1 q

c
Jjr
1 q

__
. (18)
where a = i0.
5
References
[1] Gatheral, J. (2006) The Volatility Surface: A Practitioners Guide. New
York, NY: John Wiley & Sons.
[2] Heston, S.L. (1993). "A Closed-Form Solution for Options with Stochastic
Volatility with Applications to Bond and Currency Options." Review of
Financial Studies, Vol. 6, pp 327-343.
[3] Lewis, A.L.(2000). Option Valuation Under Stochastic Volatility: With
Mathematica Code. Finance Press.
6