v
t
dW
t
v
t
2
dt, X
0
= x
0
, (1)
dv
t
= (
t
v
t
)dt +
t
v
t
dB
t
, v
0
, (2)
dW, B
t
=
t
dt,
where
v
0
the initial square of volatility.
the correlation.
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Fourier Inversion
Fourier inversion
The call price for Heston model can be written using Lewis
formula:
Call
Heston
(t, S
t
, v
t
; T, K) =S
t
e
_
T
t
q
s
ds
Ke
_
T
t
r
s
ds
2
_ i
2
+
i
2
e
izX
T
(z)
dz
z
2
iz
where X = log
_
S
t
e
_
T
t
q
s
ds
Ke
_
T
t
r
s
ds
_
and
T
(z) = E(e
z(X
T
X
t
)
F
t
)
T
(z) = E(e
z(X
T
X
t
)
F
t
).
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Fourier Inversion
Fourier inversion
The call price for Heston model can be written using Lewis
formula:
Call
Heston
(t, S
t
, v
t
; T, K) =S
t
e
_
T
t
q
s
ds
Ke
_
T
t
r
s
ds
2
_ i
2
+
i
2
e
izX
T
(z)
dz
z
2
iz
where X = log
_
S
t
e
_
T
t
q
s
ds
Ke
_
T
t
r
s
ds
_
and
T
(z) = E(e
z(X
T
X
t
)
F
t
)
T
(z) = E(e
z(X
T
X
t
)
F
t
).
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Fourier Inversion
Characteristic Function: case of constant parameters
The characteristic function
T
(z) = E(e
z(X
T
X
t
)
F
t
) is explicit
when the parameters , and are constant.
=
1
L
(0)
+
1
L
(1)
+ L
(2)
,
=Call = Call
(0)
BS
+
Correction
(1)
+
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] (3)
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] (3)
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] (3)
dX
BS
t
=
v
0,t
dW
t
v
0,t
2
dt, X
BS
0
= x
0
,
dv
0,t
= (
t
v
0,t
)dt, v
0
.
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Smart parameterization
Our approach: Proxy model
dX
BS
t
=
v
0,t
dW
t
v
0,t
2
dt, X
BS
0
= x
0
,
dv
0,t
= (
t
v
0,t
)dt, v
0
.
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Smart parameterization
Our approach: Proxy model
dX
BS
t
=
v
0,t
dW
t
v
0,t
2
dt, X
BS
0
= x
0
,
dv
0,t
= (
t
v
0,t
)dt, v
0
.
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Smart parameterization
Our approach: Proxy price
In this case the put price is P
BS
(x
0
,
_
T
0
v
0,t
dt)
we recall that P
BS
(x, y) has the following explicit expression:
P
BS
(x, y) =Ke
r
eq
T
N
_
1
y
log(
Ke
r
eq
T
e
x
e
q
eq
T
) +
1
2
y
_
e
x
e
q
eq
T
N
_
1
y
log(
Ke
r
eq
T
e
x
e
q
eq
T
)
1
2
y
_
.
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Smart parameterization
Our approach: Proxy price
In this case the put price is P
BS
(x
0
,
_
T
0
v
0,t
dt)
we recall that P
BS
(x, y) has the following explicit expression:
P
BS
(x, y) =Ke
r
eq
T
N
_
1
y
log(
Ke
r
eq
T
e
x
e
q
eq
T
) +
1
2
y
_
e
x
e
q
eq
T
N
_
1
y
log(
Ke
r
eq
T
e
x
e
q
eq
T
)
1
2
y
_
.
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Smart parameterization
How to measure errors between the model and its
proxy
Suitable parameterization
dv
t
= (
t
v
t
)dt +
t
_
v
t
dB
t
,
so that v
1
t
= v
t
and v
0
t
= v
0,t
.
Expansion w.r.t. for = 1 around = 0:
v
t
= v
0,t
.,.
the deterministic volatility
+
(v
t
)

=0
+
2
(v
t
)
2

=0
+
Question: How to estimate the derivatives
(v
t
)

=0
,
2
(v
t
)
2

=0
?
(v
t
)

=0
= e
t
_
t
0
e
s
v
0,s
dB
s
.
(v
t
)

=0
is of the order of 
.
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Smart parameterization
How to measure errors between the model and its
proxy
Suitable parameterization
dv
t
= (
t
v
t
)dt +
t
_
v
t
dB
t
,
so that v
1
t
= v
t
and v
0
t
= v
0,t
.
Expansion w.r.t. for = 1 around = 0:
v
t
= v
0,t
.,.
the deterministic volatility
+
(v
t
)

=0
+
2
(v
t
)
2

=0
+
Question: How to estimate the derivatives
(v
t
)

=0
,
2
(v
t
)
2

=0
?
(v
t
)

=0
= e
t
_
t
0
e
s
v
0,s
dB
s
.
(v
t
)

=0
is of the order of 
.
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Smart parameterization
How to measure errors between the model and its
proxy
Suitable parameterization
dv
t
= (
t
v
t
)dt +
t
_
v
t
dB
t
,
so that v
1
t
= v
t
and v
0
t
= v
0,t
.
Expansion w.r.t. for = 1 around = 0:
v
t
= v
0,t
.,.
the deterministic volatility
+
(v
t
)

=0
+
2
(v
t
)
2

=0
+
Question: How to estimate the derivatives
(v
t
)

=0
,
2
(v
t
)
2

=0
?
(v
t
)

=0
= e
t
_
t
0
e
s
v
0,s
dB
s
.
(v
t
)

=0
is of the order of 
.
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Smart parameterization
Heston price= expectation of stochastic BS price
X
T
= x
0
+
_
T
0
(
v
t
dW
t
v
t
2
dt) conditioned on the ltration
(F
B
t
)
t
generated by the Brownian motion B is:
a Gaussian distribution with mean
x
0
+
_
T
0
t
v
t
dB
t
1
2
_
T
0
v
t
dt and variance
_
T
0
(1
2
t
)v
t
dt
(Renault and Touzi 96).
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] is an
expectation of a stochastic Black Scholes Put price:
E[P
BS
(x
0
+
_
T
0
v
t
dB
t
_
T
0
2
t
2
v
t
dt,
_
T
0
(1
2
t
)v
t
dt)].
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Smart parameterization
Heston price= expectation of stochastic BS price
X
T
= x
0
+
_
T
0
(
v
t
dW
t
v
t
2
dt) conditioned on the ltration
(F
B
t
)
t
generated by the Brownian motion B is:
a Gaussian distribution with mean
x
0
+
_
T
0
t
v
t
dB
t
1
2
_
T
0
v
t
dt and variance
_
T
0
(1
2
t
)v
t
dt
(Renault and Touzi 96).
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] is an
expectation of a stochastic Black Scholes Put price:
E[P
BS
(x
0
+
_
T
0
v
t
dB
t
_
T
0
2
t
2
v
t
dt,
_
T
0
(1
2
t
)v
t
dt)].
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Smart parameterization
Heston price= expectation of stochastic BS price
X
T
= x
0
+
_
T
0
(
v
t
dW
t
v
t
2
dt) conditioned on the ltration
(F
B
t
)
t
generated by the Brownian motion B is:
a Gaussian distribution with mean
x
0
+
_
T
0
t
v
t
dB
t
1
2
_
T
0
v
t
dt and variance
_
T
0
(1
2
t
)v
t
dt
(Renault and Touzi 96).
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] is an
expectation of a stochastic Black Scholes Put price:
E[P
BS
(x
0
+
_
T
0
v
t
dB
t
_
T
0
2
t
2
v
t
dt,
_
T
0
(1
2
t
)v
t
dt)].
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Smart parameterization
Taylor expansion of the price
By performing a Taylor expansion for the P
BS
function at the
second order around
(x
0
+
_
T
0
t
v
0,t
dB
t
_
T
0
2
t
2
v
0,t
dt,
_
T
0
(1
2
t
)v
0,t
dt), we obtain
e
_
T
0
r
t
dt
E[(K e
_
T
0
(r
t
q
t
)dt+X
T
)
+
] = P
BS
(x
0
,
_
T
0
v
0,t
dt)
+ Correction terms + Errors.
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Correction terms estimation
Estimation of corrections terms
Theorem
The correction terms are a linear combination of Greeks of the
proxy Black Scholes Model:
Correction terms =
2
i=1
a
i,T
i+1
P
BS
x
i
y
(x
0
,
_
T
0
v
0,t
dt)
+
1
i=0
b
2i,T
2i+2
P
BS
x
2i
y
2
(x
0
,
_
T
0
v
0,t
dt),
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Correction terms estimation
Estimation of corrections terms
where
a
1,T
=
_
T
0
_
T
t
1
e
t
1
t
1
t
1
v
0,t
1
e
t
2
dt
1
dt
2
,
a
2,T
=
_
T
0
_
T
t
1
_
T
t
2
e
t
1
t
1
t
1
v
0,t
1
t
2
t
2
e
t
3
dt
1
dt
2
dt
3
,
b
0,T
=
_
T
0
_
T
t
1
_
T
t
2
e
2t
1
2
t
1
v
0,t
1
e
t
2
e
t
3
dt
1
dt
2
dt
3
,
b
2,T
=
a
2
1,T
2
.
t
1
t
1
v
0,t
1
e
t
2
dt
1
dt
2
,
a
2,T
=
_
T
0
_
T
t
1
_
T
t
2
e
t
1
t
1
t
1
v
0,t
1
t
2
t
2
e
t
3
dt
1
dt
2
dt
3
,
b
0,T
=
_
T
0
_
T
t
1
_
T
t
2
e
2t
1
2
t
1
v
0,t
1
e
t
2
e
t
3
dt
1
dt
2
dt
3
,
b
2,T
=
a
2
1,T
2
.
2
, p
1
=
e
T
_
T + e
T
(T 2) + 2
_
2
,
q
0
=
e
T
_
T(T + 2) + 2e
T
2
_
2
3
,
q
1
=
e
T
_
2e
T
(T 3) + T(T + 4) + 6
_
2
3
,
r
0
=
e
2T
_
4e
T
T + 2e
2T
2
_
4
3
,
r
1
=
e
2T
_
4e
T
(T + 1) + e
2T
(2T 5) + 1
_
4
3
.
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Correction terms estimation
T
2
).
Proof relies on (heavy) technical Lemmas.
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Summary
Introduction
Framework
Fourier Inversion
Review of Analytical approximations
Motivation
Smart Taylor Expansion
Smart parameterization
Correction terms estimation
Errors analysis
Numerical results
Conclusion
Bibliography
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Approximation accuracy: Strikes
Table: Set of maturities and strikes used for the numerical tests.
T/K
3M 70 80 90 100 110 120 125 130
6M 60 70 80 100 110 130 140 150
1Y 50 60 80 100 120 150 170 180
2Y 40 50 70 100 130 180 210 240
3Y 30 40 60 100 140 200 250 290
5Y 20 30 60 100 150 250 320 400
7Y 10 30 50 100 170 300 410 520
10Y 10 20 50 100 190 370 550 730
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Approximation accuracy for Constant Heston model
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Approximation accuracy for Piecewise Heston model
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Computational time: Gain by a factor of 100 or more
Table: Computational time for our approximation formula against
Fourier inversion.
Method Constant parameters
(ms)
Piecewise Constant pa
rameters (ms)
Approximation
formula
0.018 0.138
Fourier 4.708 40.225
Gain 261 291
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Summary
Introduction
Framework
Fourier Inversion
Review of Analytical approximations
Motivation
Smart Taylor Expansion
Smart parameterization
Correction terms estimation
Errors analysis
Numerical results
Conclusion
Bibliography
Introduction Smart Taylor Expansion Numerical results Conclusion Bibliography
Conclusion
The challenge is over: