Option Pricing with Mean Reversion and Stochastic Volatility

European Journal of Operational Research 197, 179-187, 2009

25 Pages Posted: 28 Mar 2008 Last revised: 13 Feb 2009

See all articles by Hoi Ying Wong

Hoi Ying Wong

The Chinese University of Hong Kong (CUHK) - Department of Statistics

Yu Wai Lo

affiliation not provided to SSRN

Date Written: January 23, 2008

Abstract

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.

Keywords: Option Pricing, Mean Reversion, Stochastic Volatility

Suggested Citation

Wong, Hoi Ying and Lo, Yu Wai, Option Pricing with Mean Reversion and Stochastic Volatility (January 23, 2008). European Journal of Operational Research 197, 179-187, 2009, Available at SSRN: https://ssrn.com/abstract=1113682 or http://dx.doi.org/10.2139/ssrn.1113682

Hoi Ying Wong (Contact Author)

The Chinese University of Hong Kong (CUHK) - Department of Statistics ( email )

Shatin, N.T.
Hong Kong

Yu Wai Lo

affiliation not provided to SSRN ( email )

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