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Option Pricing Accuracy for Estimated Heston Models

Authors :
Azencott, Robert
Gadhyan, Yutheeka
Glowinski, Roland
Publication Year :
2014

Abstract

We consider assets for which price $X_t$ and squared volatility $Y_t$ are jointly driven by Heston joint stochastic differential equations (SDEs). When the parameters of these SDEs are estimated from $N$ sub-sampled data $(X_{nT}, Y_{nT})$, estimation errors do impact the classical option pricing PDEs. We estimate these option pricing errors by combining numerical evaluation of estimation errors for Heston SDEs parameters with the computation of option price partial derivatives with respect to these SDEs parameters. This is achieved by solving six parabolic PDEs with adequate boundary conditions. To implement this approach, we also develop an estimator $\hat \lambda$ for the market price of volatility risk, and we study the sensitivity of option pricing to estimation errors affecting $\hat \lambda$. We illustrate this approach by fitting Heston SDEs to 252 daily joint observations of the S\&P 500 index and of its approximate volatility VIX, and by numerical applications to European options written on the S\&P 500 index.

Details

Database :
arXiv
Publication Type :
Report
Accession number :
edsarx.1404.4014
Document Type :
Working Paper