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The Heston Model and Its Extensions in VBA

The Heston Model and Its Extensions in VBA

Fabrice D. Rouah , Steven L. Heston (Foreword by)

ISBN: 978-1-119-00331-1

Mar 2015

352 pages



Practical options pricing for better-informed investment decisions.

The Heston Model and Its Extensions in VBA is the definitive guide to options pricing using two of the derivatives industry's most powerful modeling tools—the Heston model, and VBA. Light on theory, this extremely useful reference focuses on implementation, and can help investors more efficiently—and accurately—exploit market information to better inform investment decisions. Coverage includes a description of the Heston model, with specific emphasis on equity options pricing and variance modeling, The book focuses not only on the original Heston model, but also on the many enhancements and refinements that have been applied to the model, including methods that use the Fourier transform, numerical integration schemes, simulation, methods for pricing American options, and much more. The companion website offers pricing code in VBA that resides in an extensive set of Excel spreadsheets.

The Heston model is the derivatives industry's most popular stochastic volatility model for pricing equity derivatives. This book provides complete guidance toward the successful implementation of this valuable model using the industry's ubiquitous financial modeling software, giving users the understanding—and VBA code—they need to produce option prices that are more accurate, and volatility surfaces that more closely reflect market conditions.

Derivatives pricing is often the hinge on which profit is made or lost in financial institutions, making accuracy of utmost importance. This book will help risk managers, traders, portfolio managers, quants, academics and other professionals better understand the Heston model and its extensions, in a writing style that is clear, concise, transparent and easy to understand. For better pricing accuracy, The Heston Model and Its Extensions in VBA is a crucial resource for producing more accurate model outputs such as prices, hedge ratios, volatilities, and graphs.

Foreword xi

Preface xiii

Acknowledgments xv

About This Book xvii

VBA Library for Complex Numbers xix

Chapter 1 The Heston Model for European Options 1

Model Dynamics 1

The Heston European Call Price 2

Dividend Yield and the Put Price 8

Consolidating the Integrals 9

Black-Scholes as a Special Case 10

Conclusion 12

Chapter 2 Integration Issues, Parameter Effects, and Variance Modeling 13

Remarks on the Characteristic Functions 14

Problems with the Integrand 16

The Little Heston Trap 18

Effect of the Heston Parameters 20

Variance Modeling in the Heston Model 26

Moment Explosions 38

Bounds on Implied Volatility Slope 40

Conclusion 42

Chapter 3 Derivations Using the Fourier Transform 45

Derivation of Gatheral (2006) 46

Attari (2004) Representation 47

Carr and Madan (1999) Representation 49

Conclusion 61

Chapter 4 The Fundamental Transform for Pricing Options 63

The Payoff Transform 64

Option Prices Using Parseval’s Identity 70

Volatility of Volatility Series Expansion 75

Conclusion 81

Chapter 5 Numerical Integration Schemes 83

The Integrand in Numerical Integration 84

Newton-Cotes Formulas 85

Gaussian Quadrature 90

Integration Limits, Multidomain Integration, and Kahl and Jäckel Transformation 98

Illustration of Numerical Integration 103

Fast Fourier Transform 106

Fractional Fast Fourier Transform 108

Conclusion 114

Chapter 6 Parameter Estimation 115

Estimation Using Loss Functions 116

Speeding Up the Estimation 126

Differential Evolution 128

Maximum Likelihood Estimation 132

Risk-Neutral Density and Arbitrage-Free Volatility Surface 135

Conclusion 140

Chapter 7 Simulation in the Heston Model 143

General Setup 144

Euler Scheme 146

Milstein Scheme 147

Implicit Milstein Scheme 149

Transformed Volatility Scheme 152

Balanced, Pathwise, and IJK Schemes 155

Quadratic-Exponential Scheme 157

Alfonsi Scheme for the Variance 161

Moment-Matching Scheme 165

Conclusion 167

Chapter 8 American Options 169

Least-Squares Monte Carlo 169

The Explicit Method 174

Beliaeva-Nawalkha Bivariate Tree 178

Medvedev-Scaillet Expansion 191

Chiarella and Ziogas American Call 200

Conclusion 208

Chapter 9 Time-Dependent Heston Models 209

Generalization of the Riccati Equation 209

Bivariate Characteristic Function 210

Linking the Bivariate CF and the General Riccati Equation 212

Mikhailov and Nögel Model 214

Elices Model 219

Benhamou-Miri-Gobet Model 223

Black-Scholes Derivatives 231

Conclusion 232

Chapter 10 Methods for Finite Differences 235

The PDE in Terms of an Operator 236

Building Grids 236

Finite Difference Approximation of Derivatives 239

Boundary Conditions for the PDE 240

The Weighted Method 241

Explicit Scheme 248

ADI Schemes 251

Conclusion 256

Chapter 11 The Heston Greeks 257

Analytic Expressions for European Greeks 258

Finite Differences for the Greeks 263

Numerical Implementation of the Greeks 264

Greeks under the Attari and Carr-Madan Formulations 267

Greeks under the Lewis Formulations 273

Greeks Using the FFT and FRFT 276

American Greeks Using Simulation 279

American Greeks Using the Explicit Method 281

American Greeks from Medvedev and Scaillet 284

Conclusion 285

Chapter 12 The Double Heston Model 287

Multidimensional Feynman-Kac Theorem 288

Double Heston Call Price 288

Double Heston Greeks 292

Parameter Estimation 297

Simulation in the Double Heston Model 301

American Options in the Double Heston Model 306

Conclusion 308

Bibliography 309

About the Website 317

Index 319