Applied Mathematics Letters 26 (2013) 1–4

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Applied Mathematics Letters

journal homepage: www.elsevier.com/locate/aml

Research announcement

Option prices under stochastic volatility

Jiguang Han a,b,c , Ming Gao c , Qiang Zhang c,∗ , Yutian Li c
a
USTC-CityU Joint Advanced Research Center in Suzhou, China
b
Department of Statistics and Finance, University of Science and Technology of China, China
c
Department of Mathematics, City University of Hong Kong, Hong Kong

article info abstract

Article history: The well known Heston model for stochastic volatility captures the reality of the motion
Received 19 July 2012 of stock prices in our financial market. However, the solution of this model is expressed
Accepted 20 July 2012 as integrals in the complex plane and has difficulties in numerical evaluation. Here, we
present closed-form solutions for option prices and implied volatilities in terms of series
Keywords: expansions. We show that our theoretical predictions are in remarkably good agreement
Option pricing
with numerical solutions of the Heston model of stochastic volatility.
Stochastic volatility
Heston model
© 2012 Published by Elsevier Ltd

1. Introduction
√
The Heston model [1] assumes that dynamics of the stock s and volatility vt are governed by
√ √
ds = ν sdt + vt sdBst , dvt = κ(θ − vt )dt + ξ vt dBvt , (1)
v
where Bst
and Bt are the Brownian motions satisfying dBst dBvt
= ρ dt , µ is the rate of return of the stock, θ is the long run
average price volatility, κ is the rate at which vt reverts to θ . The volatility of the volatility is ξ and, as the name suggests,
this determines the variance of vt . Since one can introduce discounted financial instruments and a discount-factor e−qt in
the stock price process to eliminate the effect of the constant interest rate r and the dividend rate q respectively, we set q
ξ
and r to zero in this paper. For a fast mean-reverting process, one replaces κ by κϵ and ξ by √ϵ with 0 < ϵ ≪ 1; see [2].
The parameter ϵ represents the speed of fast mean reversion. An arbitrage argument shows that the option price f (t , s, v)
satisfies
κ ξ ξ 1 ξ2
 
1
ft + (θ − v) − √ λv fv + v s2 fss + √ sρv fsv + v fvv = 0 (2)
ϵ ϵ 2 ϵ 2 ϵ
with the payoff f (T , s, v) = (s − k)+ for a call and f (T , s, v) = (k − s)+ for a put, where k is the strike price and
1 √
λ(t , s, v) = λv 2 is the price of volatility risk. Since making a change of variables κ̄ = κ + ϵξ λ and θ̄ = κθ /κ̄ can
remove the effect of the price of volatility risk λ, we can set λ to zero. Thus, Eq. (2) becomes

κ 1 ξ 1 ξ2
ft + (θ − v)fv + v s2 fss + √ sρv fsv + v fvv = 0. (3)
ϵ 2 ϵ 2 ϵ
Eq. (3) has a solution expressed as two integrals of a complex function [1]. These integrals must be evaluated by numerical
methods. Several authors showed that there are difficulties in evaluating this integral numerically; see [3,4]. Therefore, it is

∗ Correspondence to: Department of Mathematics, City University of Hong Kong, Tat Chee Avenue 83, Kowloon, Hong Kong. Tel.: +852 3442 4203.
E-mail address: mazq@cityu.edu.hk (Q. Zhang).

0893-9659/$ – see front matter © 2012 Published by Elsevier Ltd

doi:10.1016/j.aml.2012.07.014
2 J. Han et al. / Applied Mathematics Letters 26 (2013) 1–4

important to develop approximate solutions for the Heston model. If we follow Fouque et al.’s method [2], we would obtain
the price expansion of European call
√
C = C0 + ϵ C1 + · · · , (4)
ξ ln(s/k)+θ (T −t )/2 √
where C0 = sN (d1 ) − kN (d2 ) and C1 = − 21 ρ κ d2 kφ(d2 ) with d1 = √
θ ( T −t )
and d2 = d1 − θ (T − t ). Then the
implied volatility expansion is
√
σˆ i = σ̂0 + ϵ σ̂1 + · · · , (5)
√ √
where σ̂0 = θ and σ̂1 = −ρξ d2 /2κ T − t. We comment that the approximate solution based on the method of Fouque
et al. [2] does not depend on the value of stochastic volatility, although the Heston model does depend on the stochastic
volatility. In this paper, we provide more accurate analytical approximate solutions for option prices and for the implied
volatility under the Heston stochastic volatility model. The predictions of our solutions are in remarkably good agreement
with numerical solutions of the Heston model and are much more accurate than the predictions based on Fouque et al.’s
method [2].

2. Main results

Our main results are stated in the following two theorems.

κτ
Theorem 1. Let τ = T − t and z = θ τ + κϵ (1 − e− ϵ )(v − θ ). The option price f has the following expansion in powers of ϵ 1/2 :
√ 3
f = f0 + ϵ f1 + ϵ f2 + ϵ 2 f3 + · · · , (6)

where

sN (d+ ) − kN (d− ) for call


f0 (s, z ) = (7)
kN (−d− ) − sN (−d+ ) for put
f1 (τ , s, z ) = g1 (τ , z )G1 (s, z ), for call and put (8)
f2 (τ , s, z ) = g2 (τ , z )G2 (s, z ) + h2 (τ , z )H2 (s, z ) + m2 (τ , z )M2 (s, z ) for call and put . (9)
√
Here d ±
= (ln(s/k) ± z /2)/ z , N (x) is the c.d.f. of the standard normal distribution and
1 ξ 1 ξ2   5
G1 (s, z ) = − ρ d− z −1 kφ(d− ), G2 (s, z ) = ρ 2 2 kφ d− z − 2 3 − 3(d− )2 − 3d+ d− + d+ (d− )3 ,

2 κ 4 κ
1 2 ξ2  − − 3  1 ξ2   3
H2 (s, z ) = − ρ 2 kφ d z 2 1 − (d ) , − 2
M2 (s, z ) = kφ d− z − 2 d+ d− − 1 ,
 
2 κ 8κ 2

1
g1 (τ , z ) = A(τ )z + θ B(τ ), g2 (τ , z ) = [A(τ )z + θ B(τ )] , 2
2
h2 (τ , z ) = C (τ )z + θ D(τ ), m2 (τ , z ) = E (τ )z + θ F (τ ),

where φ(x) is the p.d.f. of the standard normal distribution and

κ τ e−κτ /ϵ 1ϵ  −2 κτ
 ϵ − κτ
 τ e−κτ /ϵ  κτ  − κτ

A(τ ) = 1 − , F (τ ) = 1 − e ϵ − 2 1 − e ϵ + 2 − 1 − e ϵ ,
ϵ 1 − e−κτ /ϵ 2κ κ 1 − e−κτ /ϵ ϵ
κ τ 2 e−κτ /ϵ ϵ ϵ τ e−κτ /ϵ κτ 1  κτ 2
 
κτ κτ κτ
 
B(τ ) = /ϵ
− 1 − e− ϵ , D(τ ) = τ e− ϵ − 2 1 − e− ϵ + /ϵ
+ ,
ϵ 1−e −κτ κ κ 1−e −κτ ϵ 2 ϵ
e−κτ /ϵ κτ 1  κτ 2 e−κτ /ϵ  κτ
 
κτ

C (τ ) = 1 − /ϵ
+ , E (τ ) = 1 − /ϵ
2 − (1 − e− ϵ ) .
1−e −κτ ϵ 2 ϵ 1−e −κτ ϵ

Remarks. (i) f0 given by Eq. (7) resembles the Black–Scholes formula [5] with one difference, namely the dimensionless
time σ 2 (T − t ) in the classical Black–Scholes formula is replaced by z in the current case. (ii) Due to the call–put parity,
c − p = s − k, Eqs. (8) and (9) are valid for both European call and put.

Proof. After changing the variables (t , s, v) to (τ , s, z ) and expressing f as a power series of ϵ 1/2 given by Eq. (6), Eq. (3)
contains a power series in ϵ 1/2 . Since the coefficients of different powers of ϵ must be zero, we get a set of equations
 n

O ϵ2 : L0 fn + L1 fn−1 + L2 fn−2 = 0 with fn (0, s, z ) = g (s)δn , (10)
 J. Han et al. / Applied Mathematics Letters 26 (2013) 1–4 3

where fi = 0 for i < 0, δn = 1 for n = 0, δn = 0 for n ̸= 0, g (s) = (s − k)+ for call and g (s) = (k − s)+ for put. The linear
operators L0 , L1 and L2 in Eq. (10) are defined as

∂ ∂ 1 ∂2 ξ  κτ
 ∂2 1 ξ2  − κτ
2 ∂ 2
L0 = − − v + v s2 2 , L1 = 1 − e− ϵ ρv s , L2 = 1 − e ϵ v 2.
∂τ ∂z 2 ∂s κ ∂ s∂ z 2 κ2 ∂z
Although Eq. (10) looks extremely complicated, we are able to obtain closed-form expressions of the solutions of these
equations. The first three leading terms are displayed in Theorem 1. 
√
Theorem 2. The implied volatility has an expansion: σ i = σ0 + ϵσ1 + ϵσ2 + · · ·, where

1 ξ d− z −1 √ −1 1 d+ d−

z 
σ0 = , σ1 = − ρ (Az + θ B) √ , σ2 = f2 · kφ(d− ) T − t − σ12 . (11)
T −t 2 κ T −t 2 σ0

Proof. The implied volatility σ i is determined by the following equation

√
f bs (t , s; T , k, σ i ) = f (t , s, v) = f0 + ϵ f1 + ϵ f2 + · · · , (12)

where f bs is the classical Black–Scholes formula with an implied volatility σ i . The implied volatility σ i for the option f is a
function of strike price k, stock price s, the instantaneous variance v , time-to-maturity τ and other parameters. Since the
√ (12) is a function of ϵ, σ is also a function of ϵ . Thus we express the implied volatility
i
right hand side of Eq. as a power series
in ϵ : σ = σ0 + ϵσ1 + ϵσ2 + · · ·. Then we expand the left hand side of Eq. (12) in terms of ϵ 1/2 to obtain
1/2 i

√ 1
f bs (t , s; T , k, σ i ) = f bs (t , s; T , k, σ0 ) + ( ϵσ1 + ϵσ2 )fσbsi |σ =σ0 + ϵ(σ1 )2 fσbsi σ i |σ =σ0 + · · · . (13)
2
Matching the coefficients of each order in Eqs. (12) and (13) determines the implied volatility. The first three leading terms
of the implied volatility are given explicitly in Theorem 2. 

3. Validation study

Figs. 1 and 2 show the validation study of our analytical approximate solutions for option prices and implied volatilities,
respectively. In Fig. 1, we plot the ratio of the option price to the stock price f /s versus the stochastic variance v for
both correlated and uncorrelated cases. The solid curve marked with ‘‘exact solution’’ is the solution of the Heston model
evaluated by a numerical integration method proposed by Lord and Kahl [4]. The other curves are the asymptotic solutions.
The dotted curve marked
√ with ‘‘f0 ’’ is the leading term from our expansion and is given by Eq. (7). The dash–dotted curve
marked with ‘‘f0 +√ ϵ f1 ’’ represents the first two term from our expansion given by Eqs. (7) and (8). The dashed curve
√ ‘‘f0 + ϵ f1 + ϵ f2 ’’ is our approximate solution given by Eqs. (7)–(9). The cross-symbol horizontal line marked
marked with
by C0 + ϵ C1 is the prediction given by Eq. (4) and is based on Fouque et al.’s method [2]. Fig. 1 shows that our asymptotic
solutions are in excellent agreement with the exact solution of the Heston model, and the option prices increase with the
variance v . Even if we only keep the leading term in our expansions, namely f0 , the prediction already √ captures the main
features of the exact solution. The predictions from the first two terms in our expression, namely√ f0 + ϵ f1 , are very close to
the exact solution. The predictions from the first three terms in our expression, namely f0 + ϵ f1 + ϵ f2 , are almost identical
to the exact solution. The solution based on Fouque et al.’s method [2] is a horizontal line. This is due to the fact that the
prediction given by Eq. (4) only depends on the mean value θ of the stochastic volatility v , but not on v itself. Therefore, it
gives a good approximation only when the stochastic variance equals its mean value (i.e., v = θ ). However, the larger the
stochastic volatility v deviates from its mean value θ , the larger the error is in the prediction based on their approach. In
Fig. 2, we compare the results among our theoretical prediction for the implied volatility given by Theorem 2, the theoretical
prediction of Eq. (4) based on Fouque et al.’s method [2] and the implied volatility determined by the exact solution of the
Heston model. The implied volatility is plotted against the ratio k/s. Both v0 (the initial value of vt ) and θ are set to 1. The solid
curve is the exact√value of the implied volatility based on the Heston integral √ formula, the dashed curve is our theoretical
prediction σ0 + ϵσ1 + ϵσ2 , and the dotted curve is the prediction of σ̂0 + ϵ σ̂1 which was derived by the Fouque et al.’s
method [2]. Fig. 2 shows two well known phenomena on the implied volatility surfaces: skew and smile.

4. Conclusion

We derived analytical approximate solutions for the Heston stochastic volatility model in the regime of fast mean-
reversion. We give explicit formulas for the prices of European call and put options and their corresponding implied
volatilities. Validation study shows that our approximate solutions give surprisingly accurate prediction for the value of
the option.
4 J. Han et al. / Applied Mathematics Letters 26 (2013) 1–4

Fig. 1. The ratio of the option price to the stock price, f /s, is plotted against the stochastic variance v for the negatively correlated case (ρ = −0.5) and
for the uncorrelated case (ρ = 0). The parameters are: s = k, T = 0.1, κ = θ = 1, ξ = 2 and ϵ = 0.1. (a) is for the negatively correlated case (ρ = −0.5)
and (b) is for the uncorrelated case (ρ = 0). The solid curve marked with ‘‘exact solution’’ is the solution of the Heston model evaluated
√ by a numerical
integration method. The dotted curve marked with ‘‘f0 ’’ is the leading √term from Eq. (7). The dash–dotted curve marked with ‘‘f0 + ϵ f1 ’’ is the two leading
terms from Eqs. (7)√ and (8). The dashed curve marked with ‘‘f0 + ϵ f1 + ϵ f2 ’’ is our approximate solution given by Eqs. (7)–(9). The cross-symbol line
marked by ‘‘C0 + ϵ C1 ’’ is based on [2]’s method and is given by Eq. (4).

Fig. 2. The implied volatility σ i is plotted against k/s. The parameters are: κ = θ = v = 1, ξ = 2 and T = ϵ = 0.1. (a) is for a negatively correlated case
(ρ = −0.5) and (b) is for the uncorrelated case (ρ = 0). The solid curve √marked with ‘‘exact solution’’ is the solution of the Heston model evaluated by
a numerical integration
√ method. The dashed curve marked with ‘‘σ0 + ϵσ1 + ϵσ2 ’’ is our approximate solution given by Theorem 2. The dotted curve
marked by ‘‘σ̂0 + ϵ σ̂1 ’’ is based on [2]’s method and is given by Eq. (5).

Acknowledgment

The work of Q. Zhang was supported by the Research Grants Council of the Hong Kong Special Administrative Region,
China (project CityU 103509).

References

[1] S. Heston, A closed-form solution for options with stochastic volatility with applications to bond and currency options, Review of Financial Studies 6
(2) (1993) 327–343.
[2] J.P. Fouque, G. Papanicolaou, K.R. Sircar, Mean-reverting stochastic volatility, International Journal of Theoretical and Applied Finance 3 (1) (2000)
101–142.
[3] Roger W. Lee, Option pricing by transform methods: extensions, unification, and error control, Journal of Computational Finance (3) (2004).
[4] Roger Lord, Christian Kahl, Optimal fourier inversion in semi-analytical option pricing, Journal of Computational Finance (4) (2007).
[5] F. Black, M. Scholes, The pricing of options and corporate liabilities, Journal of Political Economy 81 (3) (1973) 637–654.