Mathematical Finance, Vol. 13, No.

4 (October 2003), 445–466

OPTION PRICING IN STOCHASTIC VOLATILITY MODELS

OF THE ORNSTEIN-UHLENBECK TYPE

ELISA NICOLATO
Department of Theoretical Statistics, University of Aarhus, Denmark

EMMANOUIL VENARDOS
Nuffield College, Oxford

Stochastic volatility models of the Ornstein-Uhlenbeck type possess authentic ca-

pability of capturing some stylized features of financial time series. In this work we
investigate this class of models from the viewpoint of derivative asset analysis. We
discuss topics related to the incompleteness of this type of markets. In particular, for
structure preserving martingale measures, we derive the price of simple European-style
contracts in closed form. Furthermore, the range of viable prices is determined and an
empirical application is presented.
KEY WORDS: incomplete markets, martingale measures, Ornstein-Uhlenbeck type processes, option
pricing, range of prices

1. INTRODUCTION
It is widely accepted that financial time series of different assets share a common set of
well-established stylized features. For example, log-returns are known to display heavy
tailed distributions, aggregational gaussianity, and quasi long-range dependence and
are negatively correlated with their stochastic volatilities (see Cont 2001 and references
therein). These empirical facts are successfully captured by a new class of models in which
the stochastic variance of log-returns is constructed via a mean-reverting stationary pro-
cess of the Ornstein-Uhlenbeck (OU) type driven by a subordinator. These stochastic
volatility models have been introduced and thoroughly studied by Barndorff-Nielsen
and Shephard (2001a, 2001b) and will be, hereafter, termed BN-S models. Further con-
tributions in the context of estimation can be found in Frühwirth-Schnatter and Sögner
(2001) and Dellaportas, Papaspiliopoulos and Roberts (2001); portfolio optimization
problems have been considered by Benth, Karlsen, and Reikvam (2001).
The aim of the present paper is to examine BN-S models from the viewpoint of deriva-
tive asset analysis, to investigate the incompleteness of the associated financial market,

The authors gratefully acknowledge Ole Barndorff–Nielsen, Neil Shephard, and Friedrich Hubalek
for various helpful discussions. Elisa Nicolato’s work is supported by the Centre for Analytical Finance
(www.caf.dk), which is funded by the Danish Social Science Research Council, and by the Centre for
Mathematics Physics and Stochastics (www.maphysto.dk), which is funded by the Danish National Re-
search Foundation. Emmanouil Venardos acknowledges the financial support of the Economics and Social
Research Council.
Manuscript received February 2000; final revision received July 2002.
Address correspondence to E. Nicolato, Department of Theoretical Statistics, University of Aarhus, Ny
Munkegade, DK-8000 Aarhus C, Denmark; e-mail: elisa@imf.au.dk.


C 2003 Blackwell Publishing Inc., 350 Main St., Malden, MA 02148, USA, and 9600 Garsington Road, Oxford

OX4 2DQ, UK.

445
446 E. NICOLATO AND E. VENARDOS

and to provide closed-form prices for simple derivatives like European call options. Some
of our results have been independently developed by Hubalek and Tompkins (2001).
Typically, financial markets where investors can only trade in a riskless asset and in an
underlying stock with stochastic volatility are incomplete, and in this respect BN-S models
are no exception. In this work we derive the entire set of equivalent martingale measures
(EMMs) and determine various structure preserving subclasses—that is, EMMs under
which log-returns are again described by a BN-S model, albeit with different parameters
and possibly different stationary laws. Analogous analyses have been performed by Carr
et al. (2002), and Raible (2000) for exponential Lévy models, and by Duffie, Pan, and
Singleton (2000) for affine jump diffusion models.
Under structure-preserving EMMs, we can exploit the analytical tractability of BN-S
models to price derivatives in closed form. Specifically, the Laplace transform of log-
prices has a very simple expression and, for some concrete specifications of the variance
process, it can be computed in terms of elementary functions. This allows for fast and
accurate pricing of European options using the transform-based methods initiated by
Heston (1993) and further developed in Carr and Madan (1999), Raible (2000), and Lewis
(2001). Alternatively, following Hull and White (1987) and Romano and Touzi (1997), the
price of a European contract may be computed as the expectation of the corresponding
Black and Scholes (1973) price where the volatility and the spot-price are random vari-
ables accounting for stochastic variance and leverage effect, respectively. In a risk-neutral
BN-S model, these random quantities are given by integrals of deterministic functions
with respect to a Lévy process and can be simulated using the Rosiński (1991) series
expansion. Therefore, computing prices by simulation is an efficient alternative.
When dealing with incomplete market models, it is important to determine, for a given
contract, the set of prices obtained as the pricing measure is allowed to vary over the whole
set of EMMs. Work by El Karoui and Quenez (1995) and Kramkov (1996) has shown
that the supremum of possible prices corresponds to the minimum initial value of a self-
financing strategy which superreplicates the contingent claim. Eberlein and Jacod (1997)
and Jakubėnas (1998) determined the range of prices for European call options when the
log-price of the underlying is given by a Lévy process. Incomplete markets described by
jump diffusion processes were examined by Bellamy and Jeanblanc (2000) and the case
of stochastic volatility in the context of diffusion processes was analyzed by Cvitanicé,
Pham, and Touzi (1999) and Frey and Sin (1999). In the present work, we determine the
set of viable prices of European options with convex payoff for BN-S models. We find that
the supremum of possible derivative prices coincides with the obvious upper bound given
by the current price of the underlying. Therefore, the minimal strategy to superhedge
the European call is to hold a long position in the underlying asset. On the contrary,
the infimum is strictly higher than the trivial bound and is given by the Black-Scholes
function evaluated at the current price of the underlying and at the deterministic infimum
of the volatility process.
The rest of the paper is organized as follows. BN-S models are recalled in Section 2
where we also present the two concrete specifications used throughout this work as bench-
mark models. Specifically, these are the cases where the stationary distribution of the vari-
ance process is given by the inverse Gaussian law and by the gamma law. Furthermore, we
determine and analyze the Laplace transform of the log-price. Section 3 is devoted to the
study of the set of EMMs, and in Section 4 we briefly discuss the two representations for
the price of European derivatives under structure-preserving EMMs. The range of prices
is determined in Section 5. Finally, Section 6 provides an example of the performance of
the benchmark models using European options data written on the S&P 500. The same
 OPTION PRICING IN OU TYPE STOCHASTIC VOLATILITY MODELS 447

data set was used by Duffie et al. (2000). The pricing error obtained for BN-S models
is of the same order of magnitude but we argue that a more flexible model based on
superpositions of independent OU-type processes would perform significantly better.

2. THE BN-S MODEL

2.1. The General Setup
We consider a frictionless financial market where a riskless asset with constant return
 As in Barndorff-
rate r and a risky asset (a stock) are traded up to a fixed horizon date T.
Nielsen and Shephard (2001b), we assume that the price process of the stock S = (St )
is defined on some filtered probability space (, F, (Ft )0≤t≤T, P) and is given by the
exponential exp(Xt ) with X = (Xt ) satisfying
 
(2.1) d Xt = µ + βσt2 dt + σt dW t + ρ d Zλt

(2.2) dσt2 = −λσt2 dt + d Zλt , σ02 > 0,

where the parameters µ, β, ρ, and λ are real constants with λ > 0 and ρ ≤ 0. W = (Wt )
is as usual a Brownian motion and the process Z = (Zλt ) is a subordinator—that is, it
is a Lévy process with no Gaussian component and positive increments. Adopting the
terminology introduced by Barndorff-Nielsen and Shephard (2001b), we will refer to Z
as the background driving Lévy process (BDLP). The Brownian motion W and the BDLP
Z are independent and (Ft ) is assumed to be the usual augmentation of the filtration
generated by the pair (W, Z). In this work, we assume that the BDLP Z satisfies the
following assumptions.

ASSUMPTION Z1. Z has no deterministic drift and its Lévy measure has density w(x),
so that the cumulant transform κ(θ) = log E[eθ Z1 ], where it exists, takes the form

(2.3) κ(θ ) = (eθ x − 1)w(x) d x.
R+

ASSUMPTION Z2. Letting 

θ = sup{θ ∈ R : κ(θ ) < +∞}, then 
θ > 0.

ASSUMPTION Z3. limθ→θ κ(θ) = +∞.

The solution of (2.2) can be written explicitly as

 t
(2.4) σt2 = e−λt σ02 + e−λ(t−s) d Zλs .
0

As Z is an increasing process and σ02

> 0, it is clear that the process σ 2 = (σt2 ) is strictly
positive and it is bounded from below by the deterministic function σ02 e−λt . The instan-
taneous variance of the log returns is given by (σt2 + ρ 2 λ Var[Z1 ]) dt and we will refer to
σ 2 as the variance process. An immediate consequence of assumption Z2 is that

log(x)w(x) d x < ∞.
x>2

This is a necessary and sufficient condition for the variance process σ 2 to have an in-
variant distribution which, in particular, is self-decomposable. The invariant distribution
448 E. NICOLATO AND E. VENARDOS

does not depend on the mean reversion parameter λ due to the unusual timing Zλt (see
Barndorff-Nielsen, Jensen and Sørensen, 1998, and Sato, 1999, Sec. 17, for more infor-
mation concerning processes of the OU type).
The integrated variance
 T over the time period [t, T], which is a crucial quantity in finance,
is denoted by σt,T
2∗
= t σs2 ds and a simple computation shows that
 T
−1
 −λ(T−t)
 2  
(2.5) σt,T = λ 1 − e
2∗
σt + λ−1 1 − e−λ(T−s) d Zλs .
t

The dynamics of the stock price process St = e Xt

are easily obtained by Ito’s formula and
are given by
(2.6) d St = St− (bt dt + σt d Wt + d Mt ),
where the appreciation rate bt is given by the process
 
bt = µ + λκ(ρ) + β + 12 σt2
and M = (Mt ) is the martingale Lévy process
  
Mt = eρZλs − 1 − λκ(ρ)t.
0<s≤t

Adopting the notation of Jacod and Shiryaev (1987), the process M can be expressed as
Mt = (eρx − 1)  (µ Z − ν Z)t ,
where µ Z is the random measure associated with the jumps of Z and
ν Z(ω, dt, d x) = λw(x) d x dt
is its compensator. Finally we stress that when the parameter ρ is strictly negative, a
leverage effect is incorporated in the model. Namely, whenever the variance process
jumps up the price process jumps down in agreement with the empirically observed fact
that for most equities a fall in price is associated with an increase in volatility.

2.2. Two Concrete Specifications

It is well known that for any self-decomposable law D there exists a Lévy process Z such
that the process of the OU type driven by Z has invariant distribution given by D (see Sato
1999, Sec. 17). Moreover, the cumulant function of D, denoted by κ D (θ ) = logE[eθD ],
and the cumulant function κ(θ) of Z1 are related through the formula
dκ D
(2.7) κ(θ) = θ (θ )
dθ
(see Barndorff-Nielsen 2001). It has been shown by Halgreen (1979) that inverse Gaussian
(IG) distributions are self-decomposable. Therefore, it is possible to specify the variance
process σ 2 as a so-called IG–OU process (in such a way that the stationary distribution
is given by an IG(δ, γ ) law). Since the cumulant function of IG(δ, γ ) is given by
κ IG (θ ) = δγ − δ(γ 2 − 2θ )1/2
we see from (2.7) that to obtain an IG–OU process the BDLP Z must be chosen with
cumulant function given by
 OPTION PRICING IN OU TYPE STOCHASTIC VOLATILITY MODELS 449

(2.8) κ(θ) = θδ(γ 2 − 2θ )−1/2 .

In this case the Lévy density of Z is given by

δ
w(x) = √ x− 2 (1 + γ 2 x)e− 2 γ x ,
3 1 2
(2.9)
2 2π
 +∞
and since 0 w(x) dx = +∞, the BDLP (and hence the variance process) jumps in-
finitely often in finite time intervals. The IG-OU specification of the BN-S model is of
particular interest because in the no-leverage case, ρ = 0, log returns are approximately
distributed according to a normal inverse Gaussian (NIG) law. This class of distributions
has been shown to provide very good fit to log returns of stock prices (see, e.g., Rydberg
1999 and Barndorff-Nielsen and Prause 2001).
Another popular distribution in the financial literature is the variance-gamma law and
its generalizations (see Madan and Seneta 1990; Madan, Carr, and Chang 1998; and
Carr et al. 2002). In the framework of the BN-S model, log returns are approximately
variance-gamma distributed by specifying the variance process as a -OU process, so
that the stationary distribution of σ 2 is a gamma law (ν, α). It follows from (2.7) that
such a process can be obtained when the BDLP has cumulant function given by
νθ
(2.10) κ(θ ) = .
α−θ
The BDLP of a -OU process is in fact a compound Poisson process since its Lévy density
is given by

(2.11) w(x) = να exp(−αx).

Therefore, in contrast to the IG-OU case, the -OU variance process jumps a finite
number of times in finite time intervals. Note that both in the IG–OU and in the –OU
specifications of the BN–S model, assumptions Z1, Z2, and Z3 are fulfilled.

2.3. Aggregational Results: Analysis of the Laplace Transform

In this section we compute and analyze the conditional distribution of the log-price
XT given the information up to time t ≤ T. Such a distribution will be denoted by XT|t
and its Laplace transform by

φ(z) = E [exp (zXT ) |Ft ] ,

for those z ∈ C such that the expectation is well defined. The main tool for the compu-
tations is the well-known key formula which is recalled below. The proof can be found in
Eberlein and Raible (1999).

LEMMA 2.1 (Key formula). Let Z be a subordinator with cumulant transform κ and let
f : R+ → C be a complex-valued, left continuous function such that Re( f ) ≤ 0. Then
  t  t
(2.12) E exp f (s) d Zλs = exp λ κ( f (s)) ds .
0 0

The key formula (2.12) still holds if Z satisfies condition Z2 and f is such that Re( f ) ≤

θ /(1 + ε) for ε > 0.
450 E. NICOLATO AND E. VENARDOS

The Laplace transform of the conditional integrated variance σt,T2∗

can be obtained by
a direct application of the key formula. Letting (s, T) denote the deterministic function
 
(2.13) (s, T) = λ−1 1 − e−λ(T−s) ,
it then follows from expression (2.5) that

 2∗   T
(2.14) E exp zσt,T Ft = exp zσt2 (t, T) + λκ(z(s, T )) ds
t

which is well defined for Re(z) < (t, T)−1

θ.
The key formula is now used to compute the Laplace transform φ(z).

THEOREM 2.2. In the case of the general OU-type model described in equations (2.1)
and (2.2), the Laplace transform φ(z) of XT|t is given by
  T
(t, T ) 2
(2.15) φ(z) = exp z(Xt + µ(T − t)) + (z2 + 2βz) σt + λκ( f (s, z)) ds
2 t

with (s, T) as given in (2.13) and

(2.16) f (s, z) = ρz + 12 (z2 + 2βz)(s, T).
The transform φ(z) is well defined in the open strip S = {z ∈ C : Re(z) ∈ (θ− , θ + )}, where
 √ 
θ + = inf − β − ρ(t, T)−1 + 
t≤s<T
 √ 
θ− = sup − β − ρ(t, T)−1 −  ,
t≤s<T

where  = (β + ρ(t, T)−1 )2 + 2

θ(t, T)−1 and 
θ is again as in Assumption Z2.

Proof. Let G denote the σ -algebra generated by the BDLP Z up to time T and by
Ft , and let ζ = Xt + µ(T − t). Then, proceeding by iterated conditional expectations, we
obtain
  T   T
φ(z) = E exp z ζ + βσt,T + ρ
2∗
d Zλs E exp z σs d Ws G Ft
t t
  T
1
= E exp z ζ + ρ d Zλs + (z2 + 2zβ)σt,T
2∗
Ft
t 2
  T
1 2
= exp zζ + (z + 2βz)(t, T)σt E exp
2
f (s, z) d Zλs ,
2 t

where f (s, z) is given in (2.16) and we have used the representation (2.5) for σt,T
2∗
. An easy

calculation shows that if z ∈ S then Re( f (s, z)) < θ . Hence we can apply the key formula
to obtain (2.15).

Notice that because 0 is in the interior of the domain S, all the moments of XT|t exist. In
contrast, the moments of the price level E[STN |Ft ] = φ(N) only exist when N ∈ (θ− , θ + ).
Both in the IG–OU and –OU specifications of the BN–S model the integral in expression
(2.15) can be calculated explicitly. The results of the computations are given in Table 2.1.
We conclude this section with a simple and yet fundamental result concerning the density
of XT|t .
 OPTION PRICING IN OU TYPE STOCHASTIC VOLATILITY MODELS 451

TABLE 2.1
Closed-Form Solution for the Integral Appearing in the Laplace
Transform of XT|t for the IG-OU and -OU Models
T
Integral t κ[ f (s, z)] ds
setting f1 = zρ + 12 (z2 + 2βz)(1 − e−λ(T−t) )
Process and κ(z) f2 = zρ + 12 (z2 + 2βz)
  
δ 2 − 2zρ + √ 2δ f2
IG(γ , δ)-OU λ
γ 2−2f −
1 γ
λ 2 f2 − γ 2
√ δz   2   2 
γ − 2zρ γ − 2 f1
γ 2 − 2z × arctan 2 f2 − γ 2 − arctan 2 f2 − γ 2

   
(α, ν)-OU α log αα −− f1
zρ
+ f2 λ(T − t) × λ(α− ν
f2 )
νz
α−z

COROLLARY 2.3. The distribution of XT|t is absolutely continuous with respect to the
Lebesgue measure and its density g(x) can be recovered from the transform φ through
 θ+i∞
1
(2.17) g(x) = e−zx φ(z) dz,
2π i θ −i∞
where θ is arbitrarily chosen in the open interval (θ− , θ + ) defined in Theorem 2.2.

Proof. Let θ ∈ (θ− , θ + ) be fixed and let z = θ + i ω. Proceeding again by iterated

conditional expectations and using the fact that σt,T
2∗
≥ σt2 (t, T), we obtain the following
inequality
ω2
(2.18) |φ(θ + i ω)| ≤ e− 2 σt2 (t,T)
φ(θ ).
Since σt2 > 0, it follows that
 θ+i∞  +∞
√
ω2 2π
|φ(z)| dz ≤ φ(θ) e− 2 σt2 (t,T)
dω = φ(θ ) < +∞.
θ −i∞ −∞ σt2 (t, T)
Therefore, under the Esscher transformation
dP E = eθ XT|t φ(θ )−1 dP,
the characteristic function of XT|t is absolutely integrable and is given by
φ E (iω) = φ(θ + iω)φ(θ )−1 .
Hence (2.17) follows from applying the inversion formula to φ E (iω).

2.4. Superposition of Independent OU-Type Processes

Recent empirical findings have documented the fact that the term structure of the
volatility of returns can be attributed to more than one factor (see Barndorff-Nielsen and
Shephard 2001b; Bates 1997; Duffie et al. 2000). This stylized fact can be accommodated
in the current framework by considering a superposition of N independent OU-type
processes with different persistence rates λ j according to
452 E. NICOLATO AND E. VENARDOS


N
σt2 = σ j,t
2

j =1
2
dσ j,t = −λ j σ j,t
2
dt + d Zj,λ j t σ j,0
2
> 0,

where the BDLPs Zj are mutually independent. Furthermore, one could exploit  the fact
that
 the convolution of N IG(δ j , γ ) (resp. (ν j , α)) distributions is an IG( δ j , γ ) (resp.
( ν j , α)) law. Hence, under the superposition of such factors the variance process σ 2
has the same stationary law as in the single factor case but with richer dynamics. In
particular, its autocovariance function is the sum of the individual exponential decays.
For clarity of exposition we consider, hereafter, only single factor models. However,
all of our results naturally extend to the superposition models. For example, the Laplace
exponent of the log-price is additive in the superposition factors and it is known in closed
form for the case of IG-OU (resp. -OU) factor specifications (see Venardos 2001 for
details).

3. EQUIVALENT MARTINGALE MEASURES PRESERVING

THE BN-S STRUCTURE
Recall that a probability measure Q on the space (, F, (Ft ), P) is called an equivalent
martingale measure if it is equivalent to the physical probability P and if under Q the
discounted price process e−r t St is a martingale. Denote by M the set of EMMs for the
BN-S model (2.1), (2.2).
dQ
THEOREM 3.1. Let Q ∈ M.Then the density process Lt = | is given by the Doléans-
dP Ft
Dade exponential process

(3.1) Lt = E (ψ · W + (Y − 1)  (µ Z − ν Z))t ,

where ψ = (ψt ) is a predictable process and Y = Y(ω, t, x) is a strictly positive predictable

function such that
 t 
 2
ds Y(s, x) − 1 w(x) d x < +∞ P-a.s.
0 R+

The function Y and the process ψ are linked by


  2
(3.2) µ + β + 2 σt + σt ψt + λ
1
Y(t, x)(eρx − 1)w(x) d x − r = 0,
R+

dP ⊗ dt almost surely.

Proof. By Girsanov’s theorem and the predictable representation theorem for the pair
(W, Z) there exist Y and ψ such that the density process L = (Lt ) can be written as in
(3.1), the process WQ defined by
 t
WtQ = Wt − ψs ds
0

is a Q-Brownian motion, and

ν ZQ (ω, dt, d x) = λY(ω, t, x)w(x) d x dt

 OPTION PRICING IN OU TYPE STOCHASTIC VOLATILITY MODELS 453

is the compensator of µ Z under Q (see Jacod and Shiryaev 1987, III.5a). By Itô’s formula,
the Q-dynamics of the price process St can be written as
 
(3.3) dSt = St− btQ dt + σt dW tQ + dM tQ ,
 
where MQ is the Q-local martingale MtQ = (eρx − 1)  µ Z − ν ZQ t and

  2
Q
bt = µ + β + 2 σt + σt ψt + λ
1
Y(t, x)(eρx − 1)w(x) d x.
R+

Notice that the integral in the expression for btQ

is well defined because ρ ≤ 0 and Z is
an increasing process. Finally, the Q-martingale property of e−r t St implies that btQ = r ;
that is, the pair (ψ, Y) must satisfy the relation (3.2).

The process ψ represents the risk premium associated with the Brownian motion, and
the predictable function Y − 1 can be interpreted as the risk premium associated with the
BDLP.
Note that under an arbitrary Q ∈ M, Z may not be a Q-Lévy process and (WQ , Z) may
not be Q-independent. In other words, the log-price process X may no longer be described
by a BN-S model. Let then M denote the subset of EMMs with such a property—those
Q ∈ M under which the log price process and its volatility are again described by a model
of the type (2.1), (2.2), albeit with different parameters and possibly different law for the
increments of the Lévy process Z. In order to describe M we introduce the following
class of deterministic functions:
  

 2
(3.4) Y := y : R+ → R+ | y(x) − 1 w(x) d x < +∞ ,
R+

and for y ∈ Y we set
(3.5) w y (x) = y(x)w(x).

Since R+ (1 ∧ x)w y (x) d x < ∞, we can also define

(3.6) κ (θ ) =
y
(eθ x − 1)w y (x) d x for Re(θ ) < 0.
R+

Recall also that for any y ∈ Y  the process E((y − 1)  (µ Z − ν Z)) is not only a super-
martingale but a true martingale; that is,
(3.7) E[E((y − 1)  (µ Z − ν Z))t ] = 1 ∀t ≥ 0
(see, e.g., Sato 1999, Lem. 33.6).

THEOREM 3.2. Let y ∈ Y  . Then the process

   
(3.8) ψt = σt−1 r − µ − β + 12 σt2 − λκ y (ρ) ,
where κ y is given in (3.6), is such that
  
T
(3.9) P ψs ds < ∞ = 1
2
0

and
(3.10)
y
Lt = E(ψ · W + (y − 1)  (µ Z − ν Z))t 
0≤t≤T
454 E. NICOLATO AND E. VENARDOS

is a density process. The probability measure defined by

y
dQ y = LT dP
is an EMM and the dynamics of X under Q y are given by
 
dX t = r − λκ y (ρ) − 12 σt2 dt + σt d Wy + ρ d Zλt
(3.11)
dσt2 = −λσt2 dt + d Zλt ,
y t
where Wt = Wt − 0 ψs ds is a Q y -Brownian motion and Zλt is a Q y -Lévy process. Z1 has
Lévy density w y (x) and cumulant transform κ y (θ ) given by (3.5) and (3.6) respectively,
and the processes Wy and Z are independent under Q y . Hence, Q y ∈ M .
Conversely, for any Q ∈ M , there exists a function y ∈ Y  such that Q coincides with
y
Q .

Proof. Let y ∈ Y  . The integrability property in (3.9) is immediately verified by simply

recalling that σt2 ≥ σ02 e−λt > 0. Hence the process Ly in (3.10) is a well-defined super-
martingale. Moreover, due to (3.7) and the fact that Z and W are independent, it holds
y
that E[LT] = 1; that is, Ly is a martingale. Let then Q y be the probability measure de-
d Qy y
fined by d P |Ft = Lt and let (B y , C y , ν y ) denote the characteristic triplet under Q y of the
process
 t
y
Wt − ψs ds + Zλt = Wt + Zλt
0

when the truncation function is identically equal to zero. This can be done because Z is
an increasing process. By Girsanov’s theorem, it is clear that
y y
Bt = 0, Ct = t, ν y (d x, dt) = λw y (x) d x dt,
y
with w y (x) as in (3.5), implying that Wt + Zλt is a Lévy process under Q y . In particular,
Wy is a Brownian motion, Z is a Lévy process with Lévy density w y (x) and no drift, and
Wy and Z are independent under Q y (see Sato 1999, Thm. 19.3). Clearly the dynamics
of X under Q y are given by (3.11) and since the pair (ψ, y) satisfies relation (3.2) by
construction, the discounted price process e−r t+Xt is a supermartingale. Finally, the Q y -
martingale property of e−r t+Xt follows from the independence between Wy and Z.
Conversely, let Q ∈ M and let (ψ, Y) be the associated risk premia (see Theorem 3.1).
Since Z is a Lévy process under Q, it follows immediately that the predictable function
Y has to be deterministic and time independent; that is, Y(ω, t, x) = y(x) with y ∈ Y  .
Therefore Q = Q y .

Assume that under the physical measure P the variance process σ 2 is an IG-OU process
(-OU resp.) as introduced in Section 2.2. In what follows, we determine those EMMs
under which the variance process has an invariant law in the same class, but with possibly
different parameters.

COROLLARY 3.3.

(i) Let the variance process σ 2 be IG(δ, γ )-OU under P . Then the set M IG of EMMs
preserving the IG-OU property is given by
 
1+ γ 2 x − 1 (γ 2 −γ 2 )x
(3.12) M IG = Q y ∈ M : y(x) = e 2 , 
γ ∈ R + .
1 + γ 2x
 OPTION PRICING IN OU TYPE STOCHASTIC VOLATILITY MODELS 455

Under Q y ∈ M IG , the variance process σ 2 is an IG(δ, 

γ )–OU. In particular the
parameter δ cannot be changed.
(ii) Let σt2 be (α, ν)-OU under P. The set M of EMMs preserving the -OU property
is given by
 

ν
α −(α−α)x
(3.13) M = Q y ∈ M : y(x) = e , α ∈ R+ .
ν, 
να
Under Q y ∈ M , σt2 is a (
α ,
ν) -OU process.

Proof. (i) From (2.9) and (3.5) it is clear that in order to preserve the IG-OU property
of σ 2 , the function y(x) has to be of the following form:

δ 1+
γ 2x  
y(x) = γ 2 − γ 2 )x .
exp − 12 (
δ 1+γ x
2

Therefore, we just need to check whether such a y(x) is in (3.4).  Notice that for this
to happen, it must hold that  δ = δ, otherwise the function ( y(x) − 1)2 is bounded
away from zero in a neighborhood of zero, implying that the integrability condition
1
in (3.4) cannot be satisfied (recall that in the IG-OU case, 0 w(x) dx = +∞). Let then


δ = δ. For 0 ≤ x ≤ 1 we can find a positive constant c1 such that | y(x) − 1| ≤ c1 x.
1 
Hence 0 ( y(x) − 1)2 w(x) d x < +∞. If  γ > γ , then y(x) is bounded and the finite-
∞ 
ness of 1 ( y(x) − 1)2 w(x) d x is obvious. If  γ < γ , then we can find a positive con-

stant
∞ 2 c such that | y(x) − 1| ≤ c 2 y(x) for x ∈ (1, +∞)0 and it follows from (2.9) that
1 y(x)w(x) dx < +∞. Therefore, in both cases y(x) ∈ Y  .
(ii) The proof for the -OU case is analogous to that  for the2 IG-OU case. However,
there are no parameter restrictions, since function ( y(x)  − 1) can be bounded away
from zero in a neighborhood of zero, due to the fact that R+ w(x) d x < +∞.

The subclasses M IG and M have been independently analyzed also in Hubalek and
Tompkins (2001) where it is highlighted how the parameters that cannot be modified
under an EMM can indeed be recovered from the path properties of the log-price and
variance processes.
We conclude this section by mentioning those EMMs that change the law of the BDLP
according to an Esscher transformation. This subclass, denoted by M E , is given by
(3.14) M E = {Q y : y(x) = exp{ηx}, η < 
θ }.
Notice that M E is not related to the particular stationary distribution chosen for σ 2
under P.

4. PRICING EUROPEAN VANILLA DERIVATIVES

Consider now a European style contract with payoff h(XT ). According to the fundamental
theorem of asset pricing, its arbitrage-free price at time t ≤ T is given by

(4.1) Ct = E Q e−r (T−t) h(XT ) Ft ,
where the expectation is taken with respect to Q ∈ M.
We discuss two methods to evaluate this expression under the assumption that
Q = Q y ∈ M .
456 E. NICOLATO AND E. VENARDOS

Recall from Theorem 3.2 that in this case the pair (X, σ 2 ) is a Markovian process with
BN-S dynamics given by (3.11).

4.1. Transform-Based Methods

The first technique is along the lines of Heston (1993). Let 
h(z) denote the Laplace
transform of the payoff function
 +∞

h(z) = e−zx h(x) d x
−∞

and let φ(z) be given as in (2.15) with β = − 12 and µ = r − λκ y (ρ). It is well known
that if there exists a θ belonging to the domain of definition of both transforms φ and

h and such that the inversion formula (2.17) holds, then the contract’s price admits the
representation

e−r (T−t) θ +i∞
(4.2) Ct = φ(z)
h(z) dz.
2π i θ−i∞

The implementation of the technique requires that both 

h and φ are known in closed form.
The payoff transform has been determined for a number of simple contracts (see Raible
2000, Chap. 3.4). In the particular case of European call options, 
h(z) is well defined for
Re(z) > 1. Furthermore, by Theorem 2.2 the Laplace transform of the log-price is given in
closed form in the IG-OU and -OU specifications and is well defined for Re(z) ∈ (1, θ + ).
Hence, formula (4.2) can be computed numerically for any θ ∈ (1, θ + ) using adaptive
integration software packages or more sophisticated algorithms as described in Carr and
Madan (1999), Raible (2000), and Lewis (2001).

4.2. Black-Scholes Representation

Following Hull and White (1987), an alternative representation of the derivative’s price
can be obtained as an expectation of the Black-Scholes formula with respect to particular
functionals of the BDLP. The key observation is that under Q y the conditional law of the
log-price is a normal variance-mean mixture.
Define the effective spot log-price and volatility by
Xeff = Xt + ρ(ZλT − Zλt ) − λκ y (ρ)(T − t),
σt,T
2∗ 1/2
Veff = ,
T−t
where σt,T
2∗
is given in (2.5), and let CtBS (x, v) denote the Black-Scholes price at time t of
the claim h(XT ) when the spot log-price is x and the volatility is v.
Due to the independence between the Brownian motion Wy and the BDLP Z in the
Q -dynamics of X and σ 2 , formula (4.1) can be computed via conditional expectations
y

to obtain the following expression


(4.3) Ct = E Q CtBS(Xeff , Veff ) Xt , σt2 .
If the Black-Scholes price CtBS (x, v) is known in closed form, as in the case of European
call options, expression (4.3) can be evaluated as a sample average across simulations of
the pair (Xeff , Veff ). Notice that the random terms in the effective quantities involve only
 OPTION PRICING IN OU TYPE STOCHASTIC VOLATILITY MODELS 457

integrals of deterministic functions with respect to a Lévy process. Hence, (Xeff , Veff ) can
be efficiently simulated using the work of Marcus (1987) and Rosiński (1991) on infinite
series representations of these type of integrals. A self-contained exposition of the required
results is given in Barndorff-Nielsen and Shephard (2001a), and recent developments are
surveyed in Rosiński (2001).

5. RANGE OF PRICES
In this section we address the problem of determining the set of prices spanned by the
value of a claim when the equivalent martingale measure used for the pricing varies over
the whole set M. As in Bellamy and Jeanblanc (2000), we shall restrict our attention to
plain vanilla contracts h(XT ) satisfying the following condition.

Condition H. Let H be the function expressing the payoff in terms of the price of the un-
derlying ST rather than in terms of its logarithm; that is, H(x) = h(log x).
Then H(x) is a convex function such that H(0) = 0 and 0 ≤ H(x) < x
for x > 0. Furthermore, the function G(x) = x − H(x) is bounded.

To emphasize the dependence on the particular EMM Q, we write

Ct (Q) = e−r (T−t) E Q [H(ST )|Ft ]

for the price at time t of the claim H(ST ) corresponding to Q. Recall that, no matter
which model is adopted for the underlying S, the set of viable prices It = {Ct (Q)|Q ∈ M}
is an interval due to the convexity of the set of EMMs M. Furthermore, elementary
no-arbitrage considerations imply the following inclusion
  
It ⊆ e−r (T−t) H er (T−t) St , St .

Our goal is to find out the infimum and the supremum of the interval It when the under-
lying price process is described under the physical measure P by a BN-S model.
We start by recalling the definition of Black-Scholes function for the payoff H(x)
corresponding to the case of deterministic time varying volatility.

DEFINITION 5.1. Let H be a given payoff function satisfying Condition H and let
f = ( fs ) be a deterministic and continuous function. Then, the Black-Scholes function
H f (t, x) corresponding to f is defined by

H f (t, x) = E e−r (T−t) H(YT ) Yt = x ,

where Y is described by

dYt = Yt (r dt + ft d Wt ) ;

that is, H f (t, x) is given by

    1/2  
T T
−r (T−t) 1
H (t, x) = e
f
E H xe r (T−t)
exp fs2 ds N− fs2 ds ,
t 2 t

where N is a standard normal random variable.

458 E. NICOLATO AND E. VENARDOS

It is well known that H f (t, x) belongs to C 1,2 ; it is convex in x and it satisfies

∂H f ∂H f 1 ∂ 2H f
(5.1) (t, x) + r x (t, x) + x2 f 2 (t) (t, x) − r H f (t, x) = 0.
∂t ∂x 2 ∂ x2
Our main result is as follows.

THEOREM 5.1. The supremum of the interval It of viable prices at time t coincides with
the trivial upper bound given by the current value of the underlying St

(5.2) sup It = St .

On the contrary inf It is strictly bigger than the trivial lower bound e−r (T−t) H(er (T−t) St ) and
it is given by

(5.3) inf It = Hm (t, St ),

where Hm is the Black-Scholes function corresponding to

λ
(5.4) ms = σt e− 2 (s−t) s ≥ t.

Furthermore, the set of prices It = {Ct (Q)|Q ∈ M } obtained by varying the EMMs in the
set M of EMMs preserving the BN-S structure is also an interval and

inf It = inf It and sup It = sup It .

Notice that inf It depends not only on the current value of the underlying but also on
the current value of the volatility σt through the function m given in (5.4). In particular,
given the value of the volatility process at time t, the function m is the deterministic lower
bound of the process (σs )t≥s on the time interval [t, +∞).
The proof of Theorem 5.1 will be carried out in a sequence of lemmas.

LEMMA 5.2. Hm (t, St ) is a lower bound for the set of viable prices at time t; that is,

inf It ≥ Hm (t, St ).

Proof. (The proof is along the lines of Jakubėnas 1998.) Let Q ∈ M be an arbitrary
EMM. The dynamics of the price process S under Q are given by (3.3) and applying Itô’s
formula to (Hm (T, ST ))T≥t yields
 T
∂Hm  −r s 
(5.5) e−r T Hm (T, ST ) = e−r t Hm (t, St ) + d e Ss
t ∂x
 T
∂Hm ∂Hm 1 2 ∂ H
2 m
+ e−r s + r Ss− + σs2 Ss− − r Hm ds
t ∂t ∂x 2 ∂ x2
 ∂Hm
+ e−r s Hm (s, Ss ) − Hm (s, Ss− ) − Ss .
t<s≤T
∂x
 OPTION PRICING IN OU TYPE STOCHASTIC VOLATILITY MODELS 459

Using (5.1), the convexity of Hm (s, x) and the fact that σs2 ≥ m2 (s) for s ≥ t, we get
 T
∂Hm ∂Hm 1 2 ∂ H
2 m
e−r s + r Ss− + σs2 Ss− − r Hm ds
t ∂t ∂x 2 ∂ x2
 T 
∂Hm ∂Hm 1 2 ∂ H
2 m
= e−r s + r Ss− + m2 (s)Ss− − r Hm ds
t ∂t ∂ x 2 ∂ x2
 T
1  2 ∂ 2 Hm
+ e−r s σs2 − m2 (s) Ss− ds ≥ 0.
t 2 ∂ x2
Furthermore, for any convex and differentiable function f we have

f (x) − f (y) − f  (x)(x − y) ≥ 0,

implying also that the last term in (5.5) is nonnegative. Therefore,

 T
∂Hm  −r s 
(5.6) d e Ss ≤ e−r T Hm (T, ST ) − e−r t Hm (t, St )
t ∂x
≤ e−r T ST − e−r t Hm (t, St ),

where the last inequality follows from the fact that, under Assumption H, Hm (t, x) ≤ x.
The process on the left-hand side of (5.6) is a Q-local martingale which is bounded from
above by a martingale. Hence it is a Q-submartingale starting at 0, and taking expectations
in (5.6) gives the desired result
   
E Q e−r T H(ST )Ft = E Q e−r T Hm (T, ST )Ft ≥ e−r t Hm (t, St ).

In order to prove that the set of viable prices for the claim H(ST ) spans the entire open
interval (Hm (t, St ), St ) we restrict our attention to EMMs in M and we show that

(5.7) sup It = St and inf It = Hm (t, St ).

Furthermore, it suffices to prove (5.7) for t = 0, due to the Markov property of the pair
(St , σt2 ) under Q ∈ M .
We start by considering the supremum. A necessary and sufficient condition under
which the supremum of viable prices over a subset of EMMs is equal to the extreme value
S 0 is provided in the next lemma. The result is essentially due to Frey and Sin (1999)
where only the case of a European option is considered. The proof for payoff functions H
satisfying conditions more general than those described in Assumption H can be found
in Raible (2000, Chap. 2.7).

LEMMA 5.3. Let Q1 , Q2 , . . . ∈ M be a sequence of EMMs. Then C0 (Qn ) → S 0 if and

only if the law of ST under Qn converges weakly to δ0 (the Dirac measure in 0).

Next, we show how to construct a sequence of EMMs belonging to the subclass M and
converging weakly to δ0 .

LEMMA 5.4. Let (yn ) be a sequence of functions in Y  such that

 +∞
(5.8) lim yn (x)w(x) d x = +∞
n→+∞ 1
460 E. NICOLATO AND E. VENARDOS

and let Qn denote the EMM in M which is associated to yn (x) as in Theorem 3.2. Then
limn C0 (Qn ) = S0 .

Proof. By (3.11), under Qn the price at expiry ST can be expressed as

 T
1 2∗
ST = exp r T + ρ ZλT − λTκ n (ρ) − σ0,T + σs dWsn ,
2 0

where σ0,T
2∗
is given by (2.5), W n and Z are independent, and we use the notation κ n , W n
instead of κ yn , Wyn respectively. By Markov’s inequality, for fixed  > 0 and 0 < a < 1 it
follows that
   √   1 2∗  T √ 
Qn e−r T ST >  ≤ Qn eρ ZλT −λTκ (ρ) >  + Qn e− 2 σT + 0 σs d Ws > 
n n
(5.9)
 n  2∗ 

≤  − 2 E Q ea(ρ LλT −λTκ (ρ)) + E Q e 2 (a −a)σ0,T
a n n 1 2

 2∗ 

=  − 2 eλT(κ (aρ)−aκ (ρ)) + E Q e 2 (a −a)σ0,T .
a n n n 1 2

Since for 0 < a < 1 the function f (x) = eaρx − 1 − aeρx + a is nonpositive and decreas-
ing, it holds that
 +∞
κ n (aρ) − aκ n (ρ) ≤ (ea − 1 − aeρ + a) yn (x)w(x) d x.
1

As a consequence, letting n → ∞, the first term in the last line of (5.9) converges to zero.
As for the second term in (5.9), from (2.14) and (3.6) it follows that
 T
2∗  a2 − a
log E Q e 2 (a −a)σ0,T ≤
n 1 2
κn (s, T ) ds
0 2
  T 2 
a −a
= e 2 (s,T)x − 1 yn (x)w(x) ds d x
R+ 0
 T    +∞
a 2 −a
≤ e 2 (s,T) − 1 ds yn (x)w(x) d x,
0 1

where the last inequality is obtained using the fact that for 0 < a < 1 the function
 T a2 −a
f (x) = 0 (e 2 (s,T)x − 1) ds is nonpositive and decreasing. Hence also E Q [e 2 (a −a)σ0,T ]
n 1 2 2∗

converges to zero and the conclusion follows from Lemma 5.3.

Notice that under Assumptions Z2 and Z3 a sequence (yn ) satisfying (5.8) can be
obtained considering
(5.10) yn (x) = exp(ηn x),
where (ηn ) is a sequence of real numbers such that limn→∞ ηn =  θ . In this case, the
corresponding sequence of EMMs (Qn ) belongs to the subclass M E introduced in (3.14).
We now consider the lower bound. Intuitively speaking, if it is possible to find a se-
quence of EMMs in M under which the Lévy measure of the BDLP Z converges to zero,
then the leverage effect disappears and the variance process reduces to the deterministic
infimum m2t = e−λt σ02 . Hence the price process is described, in the limit, by a Black-
Scholes model with deterministic, time-varying volatility function m, implying in turn
the convergence of the derivative price to Hm . This is the key argument in the following
lemma.
 OPTION PRICING IN OU TYPE STOCHASTIC VOLATILITY MODELS 461

LEMMA 5.5. Let (yn ) be a sequence of functions in Y  such that

(5.11) lim yn (x) = 0 and yn (x) ≤ f (x) n ≥ 1,
n→∞

where f (x) : R+ → R+ satisfies R+ (1 ∧ x) f (x)w(x) d x < +∞. Letting Qn ∈ M be the
λ
EMMs associated to yn , it holds that C0 (Qn ) → Hm (0, S0 ) where, mt = σ0 e− 2 t .

Proof. By (3.11) and Theorem 2.2, the characteristic function of XT under Qn is given
by
 T
n 1
(5.12) E Q [eiθ XT ] = exp iθ (X0 + Tr ) − (θ 2 + iθ ) m2s ds
2 0
 T
× exp λ κ n ( f (s, iθ ) ds − iθ Tκ n (ρ) , θ ∈ R,
0

where
(5.13) f (s, iθ) = ρiθ − 12 (θ 2 + iθ ) (s, T),
T
(s, T) is given in (2.13) and 0 m2s ds = (0, T)σ02 . By (3.6)
 T   T
 f (s,iθ)x 
κ ( f (s, iθ)) ds =
n
e − 1 yn (x)w(x) ds d x.
0 R+ 0

Notice that for every fixed θ ∈ R there exists a constant c > 0 such that
e f (s,iθ )x − 1 ≤ c(1 ∧ x) ∀x ∈ R+ , 0 ≤ s ≤ T.
Therefore, in virtue of Lebesgue-dominated convergence theorem
 T
lim κ n ( f (s, iθ )) ds − iθ Tκ n (ρ) = 0
n→∞ 0

and from (5.12) we see that the Qn -law ofXT convergesweakly to a normal law with
T T
mean and variance given by X0 + r T − 12 0 m2s ds and 0 m2s ds respectively. Finally,
the desired result follows immediately from the boundedness of G(x) = x − H(x) and
the Qn -martingale property of e−r t St .
A sequence of functions fulfilling (5.11) is given once again by (yn ) as in (5.10) where
(ηn ) is now a sequence of nonpositive real numbers such that ηn → −∞. Indeed, we have
shown that
inf C0 (Q) = inf  C0 (Q) = inf C0 (Q) = Hm (0, S0 )
Q∈M Q∈M Q∈M E

and
sup C0 (Q) = sup C0 (Q) = sup C0 (Q) = S0 .
Q∈M Q∈M Q∈M E

Furthermore, in a way analogous to the proof of Lemma 5.5, one finds that the map
η → C0 (Qη ), where Qη is the EMM in M E corresponding to η ∈ (−∞,  θ ), is continuous.
As a consequence, the set {C0 (Q) | Q ∈ M E } is an interval and this completes the proof
of Theorem 5.1.

As discussed in Section 4 it is particularly convenient to consider equivalent martingale

measures in M and M IG . In the next result we establish whether this choice is too
462 E. NICOLATO AND E. VENARDOS

restrictive in the sense that the range of prices is narrowed when the pricing measures are
let to vary only in these subclasses.

COROLLARY 5.6.

(i) Let σt2 be IG(δ, γ )-OU under P. Then the set ItIG = {Ct (Q) : Q ∈ M IG } is an
interval such that inf ItIG = inf It = Hm (t, St ). However sup ItIG < St .
(ii) Let σt2 be (α, ν)-OU under the physical measure P. Then the set It = {Ct (Q) :
Q ∈ M } is also an interval and inf It = inf It and sup It = sup It .

γ > 0, let Qγ denote the EMM in M IG corresponding to

Proof. (i) For 
1+
γ 2x 1 2
yγ (x) = γ − γ 2 )x
exp − (
1+γ x
2 2
(see Corollary 3.3). Defining
1 
f (x) = 2(1 + γ 2 x)−1 exp 2
γ 2x
it holds that

yγ (x) ≤ f (x) ∀
γ ∈ R+ and (1 ∧ x) f (x)w(x) d x < +∞
R+

w(x) being given by (2.9). Since

lim yγ (x) = 0 ∀x ≥ 0,

γ →+∞

Lemma 5.5 yields that inf(ItIG ) = Hm (t, St ). Reasoning as in the proof of Lemma 5.5, we
obtain that the map  γ → Ct (Qγ ) is continuous, implying that ItIG is indeed an interval.
However, we also obtain that as  γ → 0, the law of the BDLP Z1 under Qγ converges
weakly to a 2 -stable law with parameter 2δ ; that is, the cumulant transform κ 0 of the limit
1

is given by
δ√
κ 0 (z) = − −2z for Re(z) ≤ 0.
2
As a consequence, the law of ST does not converges weakly to δ0 and we can conclude,
by virtue of Lemma 5.3, that sup ItIG < St .
(ii) The second statement is immediate since from (3.13) it follows that M E ⊆ M .

TABLE 5.1
Fitted Parameters for the Two Example Models

Parameters IG(γ , δ)-OU (α, ν)-OU

ρ −4.7039 −4.4617
λ 2.4958 1.6787
BDLP γ = 11.9800 α = 116.0100
δ = 0.0872 ν = 1.0071
σ0 6.4262% 6.5883%
MSE 0.01686 0.01244
 OPTION PRICING IN OU TYPE STOCHASTIC VOLATILITY MODELS 463

IG-OU Calibration
.2 17 days .2 45 days

.15 .15

.1 .1
IG-OU Observed IG-OU Observed

.75 .8 .85 .9 .95 1 1.05 1.1 1.15 .75 .8 .85 .9 .95 1 1.05 1.1 1.15

.2 80 days .2 136 days

.15 .15

.1 .1
IG-OU Observed IG-OU Observed

.75 .8 .85 .9 .95 1 1.05 1.1 1.15 .75 .8 .85 .9 .95 1 1.05 1.1 1.15

.2 227 days .2 318 days

.15 .15

.1 .1
IG-OU Observed IG-OU Observed

.75 .8 .85 .9 .95 1 1.05 1.1 1.15 .75 .8 .85 .9 .95 1 1.05 1.1 1.15

Gamma-OU Calibration
.2 17 days .2 45 days

.15 .15

.1 .1
Gamma-OU Observed Gamma-OU Observed

.75 .8 .85 .9 .95 1 1.05 1.1 1.15 .75 .8 .85 .9 .95 1 1.05 1.1 1.15

.2 80 days .2 136 days

.15 .15

.1 .1
Gamma-OU Observed Gamma-OU Observed

.75 .8 .85 .9 .95 1 1.05 1.1 1.15 .75 .8 .85 .9 .95 1 1.05 1.1 1.15

.2 227 days .2 318 days

.15 .15

.1 .1
Gamma-OU Observed Gamma-OU Observed

.75 .8 .85 .9 .95 1 1.05 1.1 1.15 .75 .8 .85 .9 .95 1 1.05 1.1 1.15

FIGURE 5.1. Calibration of the IG-OU model (top graph) and gamma-OU model
(bottom graph) to a data set of 87 European call options on the S&P 500 index observed
on November 2, 1993. The solid-dotted lines represent the observed implied volatilities
for the six maturities and the solid lines represent the fitted implied volatilities.

6. NUMERICAL IMPLEMENTATION
To illustrate the empirical performance of OU-type models for derivatives pricing, we
consider a data set of 87 European call options for six different maturities on the S&P
500 index observed on November 2, 1993. The interest rate is 3.19% and the effect
of the dividend yield is already accounted for in the futures price. The data set was
464 E. NICOLATO AND E. VENARDOS

constructed by Yacine Aı̈ t-Sahalia and has been used in the empirical study by Duffie et al.
(2000).
We fitted the single-factor -OU and IG-OU models by minimizing the mean squared
error (MSE) defined as the average squared difference between model-produced option
prices and observed prices. The fitted parameters are given in Table 5.1 and the observed
and fitted volatility smiles are illustrated in Figure 5.1. Both models seem to perform
equally well.
The MSE reported in Duffie et al. (2000) is slightly smaller than the one reported here.
This fact can be partly attributed to the difference in the number of parameters used and
points to further research in the direction of superposition of independent OU-type pro-
cesses. Barndorff-Nielsen and Shephard (2001b) have reported a noticeable improvement
in parameter fit under the physical measure and the application to derivatives pricing is
a straightforward extension of Theorem 2.2. An interesting alternative to the calibration
method used in this example is to exploit the link of the physical and risk-neutral models
established through the study of EMMs in Section 3. This may motivate a parameter
estimation method using data from both the spot and derivatives markets along the lines
of Chernov and Ghysels (2000). Overall, we find that OU-type models deliver promising
empirical performance and we hope to provide additional empirical support in future
work.

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in Discrete and Continuous Time. Adv. Appl. Prob. 30(4), 989–1007.
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