The Heston Option Pricing Model

+
Ser-Huang Poon
June 27, 2011
If Black-Scholes (BS) is the correct option pricing model, then there can
only be one BS implied volatility regardless of the strike price of the option.
BS implied volatility smile and skew are clear evidence that market option
prices are not priced according to the BS formula. Nevertheless, the BS
implied volatility, despite all its shortcomings, has been proven overwhelm-
ingly to be the best forecast of volatility. This raises the important question
about the relationship between BS implied volatility and the true volatility.
Heston (1993), one of the most popular stochastic volatility option pric-
ing models, is motivated by the widespread evidence that volatility is sto-
chastic and that the distribution of risky asset returns has tail(s) longer than
that of a normal distribution. A SV model with correlated price and volatil-
ity innovations can address both empirical stylized facts. The SV option
pricing model was developed with a series of contributions from Johnson
and Shanno (1987), Wiggins (1987), Hull and White (1987, 1988), Scott
(1987), Stein and Stein (1991) and Heston (1993). It was in Heston (1993)
that a semi-closed form solution was derived based on characteristic function
of the price distribution.
Section 1 presents the Heston SV option pricing model starting from
the square root process, and shows the derivation of the Heston equation
from the characteristic function. Section 2 shows how one can simulate
the SV dynamics. Section 3 considers the inclusion of a jump component.
In Section 4, we simulate a series of Heston option prices from a range of
parameters. Then we use these option prices as if they were the market op-
tion prices to back out the corresponding BS implied volatilities. If market

Some of the materials are from Poon (2005) A Practical Guide for Forecasting Finan-
cial Market Volatility, Wiley, and Jondeau, Poon and Rockinger (2006) Financial Modeling
Under Non-Gaussian Distributions, Springer-Verlag London Ltd. I would like to thank
He Xue Fei for his contributions to some of the derivations.
1
option prices are priced according to the Heston dynamics, the simulations
in this section will give us some insight into the relationship between BS im-
plied volatility and the true volatility. Finally, Section 5 presents empirical
ndings on the predictive power of Heston implied volatility as a volatility
forecast.
1 Stochastic Volatility Model
The Heston (1993) stochastic volatility model is based on the following stock
price and variance dynamics
do
t
= jo
t
dt +o
t
_

t
d7
1
, (1)
d
t
= i(0
t
) dt +j
_

t
d7
2
, (2)
where i, 0, j 0 are constant parameters. The two Brownian motions, 7
1
and 7
2
, are correlated, i.e. Corr [d7
1
, d7
2
] = jdt. The dynamics of the
stock price o
t
in (1) is a geometric Brownian motion with time varying
volatility. The variance
t
in (2) follows a square root process (also known
as the Cox-Ingersoll-Ross process). As we will show below, the parameter 0
corresponds to the long-run average of
t
, and i controls the speed by which

t
returns to its long-run mean.
Given that the Heston model has two sources of randomness, the bi-
variate Itos lemma is used to derive the fundamental partial dierential
equation. The steps involved in the derivation of the Heston option pricing
formula are the same as those in the no-arbitrage derivation for the Black-
Scholes formula except that two derivative assets are required to obtain a
risk-neutral portfolio. For example, we could consider shorting a call option
C together with long positions in c units of the underlying asset and units
of a second derivative C
1
written on the same underlying. C
1
diers from C
by its maturity or strike price. Let us rewrite, using shorter notations, the
system of equations (1) and (2) as
do = j
S
dt +o
S
d7
1
,
d = j

dt +o

d7
2
.
Let C (o, , t) denote the price of a call option. We obtain from the bivariate
2
Itos lemma that the dynamics C may be written as
dC =
_
1
2
o
2
S
0
2
C
0o
2
+jo
S
o

0
2
C
0o0
+
1
2
o
2

0
2
C
0
2
+j
S
0C
0o
+j

0C
0
+
0C
0t
_
dt +o
S
0C
0o
d7
1
+o

0C
0
d7
2
.
The dynamic of the portfolio value, \ = C co C
1
, is
d\ = dC cdo dC
1
=
_
1
2
o
2
S
0
2
C
0o
2
+jo
S
o

0
2
C
0o0
+
1
2
o
2

0
2
C
0
2
+j
S
0C
0o
+j

0C
0
+
0C
0t
cj
S
_
dt

_
1
2
o
2
S
0
2
C
1
0o
2
+jo
S
o

0
2
C
1
0o0
+
1
2
o
2

0
2
C
1
0
2
+j
S
0C
1
0o
+j

0C
1
0
+
0C
1
0t
_
dt
+
_
o
S
0C
0o
co
S
o
S
0C
1
0o
_
d7
1
+
_
o

0C
0
o

0C
1
0
_
d7
2
. (3)
To obtain risk neutrality, the coecients of d7
1
and d7
2
must be zero, so
that the two sources of uncertainty no longer play a role in the portfolio
value dynamic. This means that
0C
0o
= c +
0C
1
0o
, (4)
0C
0
=
0C
1
0
. (5)
With these two conditions, the instantaneous change of value of the fully
hedged portfolio must be equal to the return on a risk-free investment. Oth-
erwise there will be an arbitrage opportunity. Hence,
d\ = r [C co C
1
] dt. (6)
If we equate (3) and (6), and substitute the values of c and from (4) and
(5), we obtain
_
1
2
o
2
S
0
2
C
0o
2
+jo
S
o

0
2
C
0o0
+
1
2
o
2

0
2
C
0
2
+ro
0C
0o
+j

0C
0
+
0C
0t
rC
__
0C
0
=
_
1
2
o
2
S
0
2
C
1
0o
2
+jo
S
o

0
2
C
1
0o0
+
1
2
o
2

0
2
C
1
0
2
+ro
0C
1
0o
+j

0C
1
0
+
0C
1
0t
rC
1
__
0C
1
0
.
Interestingly, the two sides of the equality sign are the same in their ex-
pression, diering only in the option to which they apply. Given that the
same equation must hold for any type of call option of any maturity and
strike price, then each side of the equality must be independent from the
3
type of option that one considers. This suggests that each side will be equal
to some function, say `(o, , t) that depends on o and . This function may
be interpreted as a volatility risk premium. Replacing the parameters by
their actual units, we see that the fundamental partial dierential equation
is now
0 =
1
2
o
2
0
2
C
0o
2
+jjo
0
2
C
0o0
+
1
2
j
2

0
2
C
0
2
+ro
0C
0o
+[i(0 ) `(o, , t)]
0C
0
rC +
0C
0t
. (Heston eq6)
Heston (1993) makes the important assumption that the volatility risk pre-
mium is a linear function of
t
such that `(o, , t) = `. Moreover, intro-
ducing r = lno or o = c
a
, we have
0C
0o
=
0C
0r
0r
0o
=
1
o
0C
0r
= c
a
0C
0r
0
2
C
0o
2
=
0
0r
_
0C
0o
_
0r
0o
=
0
0r
_
c
a
0C
0r
_
0r
0o
=
_
c
a
0C
0r
+c
a
0
2
C
0r
2
_
0r
0o
=
_

1
o
0C
0r
+
1
o
0
2
C
0r
2
_
1
o
=
1
o
2
0C
0r
+
1
o
2
0
2
C
0r
2
0
2
C
0o0
=
0
0r
_
0C
0
_
0r
0o
=
1
o
0
2
C
0r0
Substitute the results into (Heston eq6) to obtain
0 =
1
2

t
0
2
C
0r
2
+jj
t
0
2
C
0r0
+
1
2
j
2

t
0
2
C
0
2
+[i(0
t
) `
t
]
0C
0
+
_
r
1
2

t
_
0C
0r
rC +
0C
0t
. (7)
The key dierence between (Heston eq6) and (7) is that the coecient of the
partial derivatives does not contain o (or r) making the PDE a lot easier
to solve. In the case of a European Call option, we have the following
boundary conditions:
C(o
T
, , T) = max(o
T
1, 0), (8)
C(0, , t) = 0, (9)
0C
0o
t
(, , t) = 1. (10)
By analogy with the Black-Scholes formula, the guessed solution of this
European option is of the form
C(o, , T) = o1
1
c
vt
11
2
= c
a
1
1
c
vtvT
11
2
(11)
4
where 1
1
and 1
2
are cumulative density functions in relation to the money-
ness of the option at maturity. From (11), we obtain the following partial
derivatives:
0C
0r
= c
a
1
1
+c
a
01
1
0r
c
vtvT
1
01
2
0r
0
2
C
0r
2
= c
a
1
1
+ 2c
a
01
1
0r
+c
a
0
2
1
1
0r
2
c
vtvT
1
0
2
1
2
0r
2
0C
0
= c
a
01
1
0
c
vtvT
1
01
2
0
0
2
C
0
2
= c
a
0
2
1
1
0
2
c
vtvT
1
0
2
1
2
0
2
0
2
C
0r0
= c
a
01
1
0
+c
a
0
2
1
1
0r0
c
vtvT
1
0
2
1
2
0r0
0C
0t
= c
a
01
1
0t
rc
vtvT
11
2
c
vtvT
1
01
2
0t
Substitute these partial derivatives into (7) to give
c
a
[) (1
1
)] c
vtvT
1 [) (1
2
)] = 0 (12)
where ) (1
i
) with i = 1, 2 is a polynomial function of 1
i
. A solution for
(12) is
) (1
1
) = ) (1
2
) = 0
which means
) (1
1
) =
1
2

t
0
2
1
1
0r
2
+jj
t
0
2
1
1
0r0
+
1
2
j
2

t
0
2
1
1
0
2
+
_
r +
1
2

t
_
01
1
0r
+[i(0
t
) `
t
+jj
t
]
01
1
0
+
01
1
0t
= 0
and
) (1
2
) =
1
2

t
0
2
1
2
0r
2
+jj
t
0
2
1
2
0r0
+
1
2
j
2

t
0
2
1
2
0
2
+
_
r
1
2

t
_
01
2
0r
+[i(0
t
) `
t
]
01
2
0
r1
2
+r1
2
+
01
2
0t
= 0
Alternatively, as presented in Heston equation (12),
1
2

t
0
2
1
)
0r
2
+jj
t
0
2
1
)
0r0
+
1
2
j
2

t
0
2
1
)
0
2
+ (r +n
)

t
)
01
)
0r
+[a /
)

t
]
01
)
0
+
01
)
0t
= 0 (Heston eq12)
for , = 1, 2, where n
1
=
1
2
, n
2
=
1
2
, a = i0, /
1
= i +` jj, /
2
= i +`.
5
Indeed the cumulative probability functions 1
)
in (Heston eq12) are not
immediately available in closed form. On the other hand, it can be shown
that their characteristic functions )
)
(r, , T; c) must satisfy the same PDEs
in (Heston eq12) subject to the terminal condition
)
)
(r, , T; c) = c
ia
.
Assuming that the characteristic function has the solution
)
)
(r, , T; c) = c
C+1+ia
(13)
where C and 1 are functions of (T t). Hence, the task now is to nd
suitable C and 1 such that )
)
(r, , T; c) satises
1
2

t
0
2
)
0r
2
+jj
t
0
2
)
0r0
+
1
2
j
2

t
0
2
)
0
2
+(r +n
)

t
)
0)
0r
+ [a /
)

t
]
0)
0
+
0)
0t
= 0 (Heston A4)
From (13)
0)
0r
= ic),
0
2
)
0r
2
= c
2
)
0)
0
= 1),
0
2
)
0
2
= 1
2
)
0
2
)
0r0
= ic1),
0)
0t
=
_
0C
0t
+
01
0t
_
)
Substitute these partial derivatives into (Heston A4) and obtain

1
2

t
c
2
) +jj
t
ic1) +
1
2
j
2

t
1
2
) + (r +n
)

t
) ic)
+[a /
)

t
] 1) +
_
0C
0t
+
t
01
0t
_
) = 0
_

1
2
c
2
+jjic1 +
1
2
j
2
1
2
+n
)
ic /
)
1 +
01
0t
_
+
_
ric +a1 +
0C
0t
_
= 0
This gives rise to a system of two Ricatti equations:

1
2
c
2
+jjic1 +
1
2
j
2
1
2
+n
)
ic /
)
1 +
01
0t
= 0
ric +a1 +
0C
0t
= 0
6
Solving the pair of Ricatti equations, using e.g. mathematica, gives the
solution for (13) with
C(t; c) = rict +
a
j
2
_
(/
)
jjic +d)t 2 ln
_
1 qc
ot
1 q
__
1(t; c) =
/
)
jjic +d
j
2
_
1 c
ot
1 qc
ot
_
,
and
q =
/
)
jjni +d
/
)
jjni d
,
d =
_
(jjic /
)
)
2
j
2
(2n
)
ic c
2
),
From the Fourier inversion theorem, we have
1 (r) =
1
2

1

_
1
0
Re
_
c
ia
)(c)
ic
_
dc,
Pr [A r] = 1 1 (r) =
1
2
+
1

_
1
0
Re
_
c
ia
)(c)
ic
_
dc.
Hence, we can write 1
1
and 1
2
in (11) as
1
)
=
1
2
+
1

_
1
0
Re
_
c
iln 1
)
);a
t
,
t
,t
(c)
ic
_
dc,
with , = 1, 2. Carr and Madan (1999) and Bakshi and Madan (2000) show
how to use the fast Fourier method to evaluate the integral.
2 Simulating the SV dynamics
In the previous section, we considered the simpler and straightforward case
of a European call option. Invoking the put-call parity, the European put
price can be deduced. There are situations, e.g. pricing path dependent
options, where we have to simulate trajectories either under the risk-neutral
probability or under the objective probability. In this case, we will need the
system of stochastic dierential equations and the associated PDE. This can
be done by analogy. Indeed, for
do = j
S
dt +o
S
d7
1
, (14)
d = j

dt +o

d7
2
, (15)
7
and instantaneous correlation Corr [d7
1
, d7
2
] = jdt, the transition proba-
bility j(o
T
,
T
[o, ) must satisfy
1
2
o
2
S
0
2
j
0o
2
+jo
S
o

0
2
j
0o0
+
1
2
o
2

0
2
j
0
2
+j
S
0j
0o
+j

0j
0
+
0j
0t
= 0.
Inspection of the PDE in (Heston eq12) for the case , = 2, where the
transition probability is risk neutral, shows that
j
S
= r
1
2

t
, o
S
=
_

t
, j

= i(0
t
) `
t
, o

= j
_

t
.
If we also decompose d7
1
into
d7
1
= jd7
2
+
_
1 j
2
d
~
7
1
, (16)
where
~
7
1
is a Brownian motion and where d7
2
and d
~
7
1
are uncorrelated,
then we get
dr
t
=
_
r
1
2

t
_
dt +
_

t
_
jd7
2
+
_
1 j
2
d
~
7
1
_
, (17)
d
t
= [i(0
t
) `
t
] dt +j
_
d7
2
. (18)
Since Corr
_
d
~
7
1
, d7
2
_
= 0, d
~
7
1
and d7
2
can be simulated separately and
then linked via (17) to yield a correlated process.
If we introduce the notations i

= i +` and 0

= i0, (i +`), equation

(16) can also be written as
d
t
= i

(0

t
) dt +j
_

t
d7
2
. (19)
Using the system (17) with either (18) or (19), it is possible to simulate risk
neutral trajectories using a rst or second-order discretization scheme. The
dierence between (14) and (17) is the replacement of j by r. The dierence
between (18) and (19) is the replacement of i, 0 and ` by the risk neutral
equivalent i

and 0

. That is the risk neutral parameters i

and 0

have
absorbed `, the volatility risk premium. Both (18) and (19) are risk neutral
SDEs.
3 Combining stochastic volatility with jumps
Bates (1996) considers a compensated jump-diusion process with variance
following a square-root process as in Heston (1993). The full model is
do
t
= (j `J)o
t
dt +
_

t
o
t
d7
1
+o
t
J
t
d, (20)
d
t
= (c ,
t
)dt +j
_

t
d7
2
. (21)
8
The term `J is the expected instantaneous jump size. As the price process is
compensated, i.e., the jump contribution in the drift will be zero. Moreover,
Co [d7
1
, d7
2
] = jdt, (22)
Pr [d
t
= 1] = `dt, (23)
log (1 +J
t
) ~ A
_
log
_
1 +J
_

1
2
c
2
, c
2
_
. (24)
where J
t
is the stochastic jump, expressed as a percentage, whenever a jump
takes place. The last equation, (24), denes 1 + J
t
as a log-normal jump.
Hence,
1[1 +J
t
] = exp
_
log(1 +J)
1
2
c
2
+
1
2
c
2
_
= 1 +J,
and thus
1[J
t
] = J.
Furthermore as 1[J
t
d] = `Jdt, this result shows that the expected jump
contribution is zero per time unit in equation (20) because the jump com-
ponent has been compensated by the introduction of `Jdt in the mean.
Next, we proceed to solve the PDE associated with equations (20) to
(24). Let us start with the univariate jump diusion given by
do
t
= a dt +/ d7
t
+cJ
t
d.
Let /(o
T
) be some integrable function and dene
c(o, t) = 1 [/(o
T
)[o, t] =
_
c
T
/(:
T
)j(:
T
, T[o, t)d:
T
,
the latter integral involving the transition probability. Given that the prob-
lem is Markovian, the Chapman-Kolmogorov equation still holds and using
the argument of iterated expectations as we did for Hestons model, it is
possible to show that c is a martingale. It follows that its drift must be
zero, or in other terms that the expected instantaneous variation must be
zero. We may use the Ito formula for diusions involving jump-processes to
obtain
1
0 = 1[dc] =
_
c
T
/(:
T
)
__
1
2
/
2
0
2
j
0:
2
+a
0j
0:
+
0j
0t
_
dt +/
0j
0:
d7
+ ([j(:
t
+c
t
J, t) j(:
t
, t)] d
_
d:
T
,
1
This extension of Itos lemma to processes with discrete jumps is immediate.
9
where we suppressed the arguments (:
T
, T) guring in the transition proba-
bilities. We notice that there are two components to the drift term. One due
to the diusion part and the other due to the jump part. The expectation
of the Brownian motion part, d7
t
is nil and thus it must be that
_
c
T
/(:
T
)
__
1
2
/
2
0
2
j
0:
2
+a
0j
0:
+
0j
0t
_
dt
+1 [j(:
t
+c
t
J
t
, t) j(:
t
, t)] d
t

_
d:
T
= 0.
Given that this equation must hold for all /(.) functions, it must also be
true for Dirac functions. It follows, using the fact that the jump size J
t
and
the Poisson process are independent that
1
2
/
2
0
2
j
0:
2
+a
0j
0:
+
0j
0t
+`1[j(:
t
+c
t
J
t
, t) j(:
t
, t)] = 0,
an expression called the innitesimal generator of the jump diusion. This
is the PDE that the transition probability of a jump diusion must obey,
i.e. with an additional expectation term due to the jump component.
Expanding the notations for a, / and c, Bates obtains the following PDEs
for the transition probability
0j
0t
+
_
r `

J
1
2

t
_
0j
0:
+ (c ,

t
)
0j
0
+
1
2

t
_
0
2
j
0:
2
+ 2jj
0
2
j
0:0
+j
2
0
2
j
0
2
_
+`

1[j(:
t
+

, t) j(:
t
, t)] = 0,
(25)
with

= log(1 +J

) ~ A
_
log(1 +J

)
1
2
c
2
, c
2
_
.
The parameters `

, ,

, and J

are risk neutral. In the case of a European

call option with maturity date T, strike price 1 and parameter vector 0,
the pricing formula is
C(o
t
, T, t, 1, 0) = o
t
1
1
(o
T
ln1) 1c
vt
1
2
(o
T
ln1),
where 1
1
and 1
2
are survival functions. The dierential equations associated
with 1
2
follows, as in Heston, from the construction of a non-arbitrage
portfolio. The partial dierential equation associated with 1
1
follows by
recognizing that C must follow the same partial dierential equation as 1
2
.
2
2
The appendix in Bakshi, Cao, and Chen (1997) also provides details on the various
PDEs and guidence on how to solve them.
10
A characteristic function that will solve the PDE in (25) can be guessed
in the usual way given the linearity of the problem
)(c; o, , t) = c
(,t)+1(,t)+iS
.
Bates derives
C(o, T, t, 1, ) = o 1
1
1 c
vt
1
2
,
1
)
=
1
2
+
1

_
1
0
Re
_
)
);a,,t
(c)c
iln 1
ic
_
dc, for , = 1, 2
where
)
);a,,t
(c) = 1[c
iA
T
]
= exp
_

)
(t, c) +1
)
(t, c)
t
+ico +`

t(1 +J

)
&
j
+
1
2
[(1 +J

)
i
c
c
2
(&
j
i
1
2

2
)1
_
,
and
1
)
(t, c) = (r `

)ict
ct
j
2
(jjic ,
)

)
)

2c
j
2
log
_
1 +
1
2
(jjic ,
)

)
)
1 c

j
t

)
_
.

)
(t; c) = 2
n
)
ic
1
2
c
2
jjic ,
)
+
)
(1 +c

j
t
),(1 c

j
t
)
,

)
=
_
(jjic ,
)
)
2
2j
2
_
n
)
ic
1
2
c
2
_
,
n
1
=
1
2
, n
2
=
1
2
, ,
1
= ,

jj, and ,
2
= ,

.
This formula is again relatively straightforward to implement. As before,
some care is needed in the computation of the inverse Fourier transform
since the integrand is an oscillating function.
Bates also shows that the risk neutral counterparts to equations (20)
(24) are
do
t
,o
t
= (r `

)dt +
_
d7

1
+J

d,
d = [c ,

]dt +j
_
d7

2
,
Co [d7

1
, d7

2
] = jdt,
Pr [d

= 1] = `

dt,
1

[J

] = J

.
11
All starred variables represent risk neutral versions of the actual variables.
This system of equations may be discretized with a ne rst or second-order
scheme as the basis for simulations. The model of Bakshi, Cao, and Chen
(1997) is similar to Batess, but with the extension to include a square-root
process for interest rate as well.
4 Heston parameters and BS implied
In this Section, we analyse possible BS implied bias by simulating a series
of Heston option prices using asset price o = 100, interest rate r = 0, time
to maturity T = 1 year, and strike prices range from 50 to 150. There
are ve other parameters used in Heston formula; namely, i, the speed of
mean reversion, 0, the long-run volatility level, `, the market price of risk,
j, volatility of volatility, and j, the correlation between the price and the
volatility processes. When ` = 0, the volatility process becomes risk neutral,
and i and 0 become i

and 0

respectively. In most simulations, and unless

otherwise stated, i = 0.1, 0 = 20%, ` = 0, j = 0.6, j = 0 and the current
instantaneous volatility,
t
, is set equal to the long run level, 0, at 20%.
Figure 1: Black-Schole Series (Skewness=0, Kurtosis=3)
The rst set of simulations presented in Figure 1 involves replicating the
Black-Scholes prices as a special case. Here we set j = 0. Since there
is no volatility risk, ` = 0. This is a special case where Heston price and
Black-Scholes price are identical and the BS implied volatility is the same
12
across strike prices. In this special case, BS implied volatility (at any strike
price) is a perfect representation of true volatility of 20%.
Figure 2: Eect of j (j =VV, /nr = 1nrto:i:, i = 0.1)
In the second set of simulations presented in Figure 2, we alter j, the
volatility of volatility, and keep all the other parameters the same. The
eect of an increase in j is to increase the unconditional volatility and kur-
tosis of risk neutral price distribution.
3
In this case where volatility is
stochastic, true volatility is
_
T
0

t
dt and can be derived from (2) and should
be bounded between the min and max points of the vol smile which in Figure
2 correspond to the OTM and ATM implied vol. Hence, we can conclude
that ATM implied vol underestimates true volatility while OTM implied vol
overestimates it. Assuming that j is constant over time, and that j and `
are relatively stable, a time series regression of historical actual volatility
on historical implied volatility at a particular strike will be sucient to
correct for these biases. This is basically the Ederington and Guan (1999)
approach. However, j is not likely to be stable. When j is not constant,
the analysis below and Figure 3 shows that ATM implied volatility is least
aected by changing j. This explains why ATM implied volatility is the
most robust and popular choice of volatility forecast.
3
It is the risk neutral distribution because , the market price of risk, is set equal to
zero.
13
2
Figure 3: Eect of Correlation, j
In Figure 3, it is clear that changing correlation coecient alone has
no impact on ATM implied volatility. Correlation has the greatest impact
on skewness of the price distribution and determines the shape of volatility
smile or skew. Its impact on kurtosis is less marked when compared with
j, the volatility of volatility.
Figure 4 highlights the impact of i, the mean reversion parameter when
j = 0.6, 0 = 0.2, and ` = 0. High rate of mean reversion i, or high initial
volatility
t
has the eect of attening the vol smile as it becomes hard to
distinguish a stock price with a very high volatility and a stock price with a
stochastic volatility. When this is the case, there is no strike price bias in
BS implied (i.e. there will not be volatility smile). When i is low, this is
when the problem starts. A low i corresponds with volatility persistence
where BS implied volatility will be sensitive to the current state of volatility
level. Strike price eect or the volatility smile is the most acute when initial
volatility level
t
is low. Similar to the situation with high vol of vol j,
ATM implied vol will underestimate true vol vis-a-vis OTM options.
Figure 5 and 6 can be used to infer the impacts of parameter estimates
above when the volatility risk premium ` is omitted. In the literature, we
often read ... volatility risk premium is negative reecting the negative
correlation between the price and the volatility dynamics ... (Buraschi and
14
Figure 4: Eect of i (j = 0.6, 0 = 0.2)
Jackwerth (2001), Bakshi and Kapadia (2003)). All series in Figure 5 have
correlation j = 0.5 and all series in Figure 6 have correlation j = +0.5. A
negative ` (volatility risk premium) produces higher Heston price and higher
BS implied volatility. The impact is the same whether the correlation j
is negative or positive. Empirical evidence indicates that Figure 6 is just
as likely a scenario as Figure 5. As i

= i + ` and 0

=
i0
i+A
, a negative
` has the eect of reducing i

(slower mean reversion) and increasing 0

(higher long run mean), and a higher option price. Hence, a negative risk
premium is to be expected whether the price and the volatility processes
are positively or negatively correlated.
4
Both volatility and volatility risk
premium have positive impact on option price.
5 Volatility forecast using Heston model
The thick tail and non-symmetrical distribution found empirically could be a
result of volatility being stochastic. The simulations results in the previous
section suggest that j, the volatility of volatility is the main driving force for
kurtosis and skewness (if correlation not equal to zero). A high i, volatility
4
This is really a misnomer, while the parameter is negative, it actually results in a
higher option price. So strictly speaking the volatility risk premium is positive!
15
Figure 5: Eect of ` on negatively correlated processes (j = 0.5,
o/cn:c:: = +0.1623, 1nrto:i: = 3.7494)
mean reversion will cancel out much of the j impact on kurtosis and some of
that on skewness. Correlation between the price and the volatility processes,
j, determines the sign of the skewness. But beyond that its impact on the
magnitude of skewness is much less compared with the combined eect of
j and i. Correlation has negligible impact on kurtosis. The long run
volatility level, 0, has very little impact on skewness and kurtosis, except
when j is very high and i is very low. So a stochastic volatility pricing
model is useful and will out perform Black-Scholes only when volatility is
truly stochastic (i.e. high j) and volatility is persistence (i.e. low i). The
diculty with the Heston model is that a large combinations of parameter
values can produce similar skewness and kurtosis. This contributes to model
parameter instability and convergence diculty during estimation.
Through simulation results we can predict the degree of Black-Scholes
pricing bias as a result of stochastic volatility. In the case where volatility
is stochastic and j = 0, ATM implied volatility will be lower than actual
volatility while implied volatility of far-from-the-money options (i.e. either
very high or very low strikes) will be higher than actual volatility. The
pattern of pricing bias will be much harder to predict if j is not zero and
varies through time. Some of the early work on option implied volatility
focus on nding an optimal weighting scheme to aggregate implied volatility
of options across strikes. (See Bates (1996) for a comprehensive survey of
16
Figure 6: Eect of ` on positively correlated processes (j = 0.5, o/cn:c:: =
0.1623, 1nrto:i: = 3.7494)
these weighting schemes.) Since the plot of implied volatility against strikes
can take many shapes, it is not likely that a single weighting scheme will
consistently remove all pricing errors. For this reason and together with the
liquidity argument, ATM option implied volatility is often used for volatility
forecast but not implied volatilities at other strikes.
17
References
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[3] Bates D.S. (1996) Testing option pricing models, in Maddala G.S. and
C.R. Rao eds. Handbook of Statistics, v.14: Statistical methods in
Finance, Elsevier, Amsterdam: North Holland, pp.567-611.
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18