Simulating the Heston Model
Importing open source libraries
import numpy as np
import seaborn as sns
import matplotlib.pyplot as plt
from py_vollib_vectorized import vectorized_implied_volatility as implied_vol
Parameteres
S0 = 100.0 # asset price
T = 1.0 # time in years
r = 0.02 # risk-free rate
N = 252 # number of time steps in simulation
M = 1000 # number of simulations
# Heston dependent parameters
kappa = 3 # rate of mean reversion of variance under risk-neutral dynamics
theta = 0.20**2 # long-term mean of variance under risk-neutral dynamics
v0 = 0.25**2 # initial variance under risk-neutral dynamics
rho = 0.7 # correlation between returns and variances under risk-neutral dynamics
sigma = 0.6 # volatility of volatility
theta, v0
(0.04000000000000001, 0.0625)
Monte carlo simulation
def heston_model_sim(S0, v0, rho, kappa, theta, sigma,T, N, M):
"""
Inputs:
- S0, v0: initial parameters for asset and variance
- rho : correlation between asset returns and variance
- kappa : rate of mean reversion in variance process
- theta : long-term mean of variance process
- sigma : vol of vol / volatility of variance process
- T : time of simulation
- N : number of time steps
- M : number of scenarios / simulations
Outputs:
- asset prices over time (numpy array)
- variance over time (numpy array)
"""
# initialise other parameters
dt = T/N
mu = np.array([0,0])
cov = np.array([[1,rho],
[rho,1]])
# arrays for storing prices and variances
S = np.full(shape=(N+1,M), fill_value=S0)
v = np.full(shape=(N+1,M), fill_value=v0)
# sampling correlated brownian motions under risk-neutral measure
Z = np.random.multivariate_normal(mu, cov, (N,M))
for i in range(1,N+1):
S[i] = S[i-1] * np.exp( (r - 0.5*v[i-1])*dt + np.sqrt(v[i-1] * dt) * Z[i-1,:,0] )
v[i] = np.maximum(v[i-1] + kappa*(theta-v[i-1])*dt + sigma*np.sqrt(v[i-1]*dt)*Z[i-1,:,1],0)
return S, v
rho_p = 0.98
rho_n = -0.98
S_p,v_p = heston_model_sim(S0, v0, rho_p, kappa, theta, sigma,T, N, M)
S_n,v_n = heston_model_sim(S0, v0, rho_n, kappa, theta, sigma,T, N, M)
Plotting Data
fig, (ax1, ax2) = plt.subplots(1, 2, figsize=(12,5))
time = np.linspace(0,T,N+1)
ax1.plot(time,S_p)
ax1.set_title('Heston Model Asset Prices')
ax1.set_xlabel('Time')
ax1.set_ylabel('Asset Prices')
ax2.plot(time,v_p)
ax2.set_title('Heston Model Variance Process')
ax2.set_xlabel('Time')
ax2.set_ylabel('Variance')
plt.show()
Asset Price distribution with different correlations
# simulate gbm process at time T
gbm = S0*np.exp( (r - theta**2/2)*T + np.sqrt(theta)*np.sqrt(T)*np.random.normal(0,1,M) )
fig, ax = plt.subplots()
ax = sns.kdeplot(S_p[-1], label=r"$\rho= 0.98$", ax=ax)
ax = sns.kdeplot(S_n[-1], label=r"$\rho= -0.98$", ax=ax)
ax = sns.kdeplot(gbm, label="GBM", ax=ax)
plt.title(r'Asset Price Density under Heston Model')
plt.xlim([20, 180])
plt.xlabel('$S_T$')
plt.ylabel('Density')
plt.legend()
plt.show()
Volatility smile
rho = -0.7
S,v = heston_model_sim(S0, v0, rho, kappa, theta, sigma,T, N, M)
# Set strikes and complete MC option price for different strikes
K = np.arange(20,180,2)
puts = np.array([np.exp(-r*T)*np.mean(np.maximum(k-S,0)) for k in K])
calls = np.array([np.exp(-r*T)*np.mean(np.maximum(S-k,0)) for k in K])
put_ivs = implied_vol(puts, S0, K, T, r, flag='p', q=0, return_as='numpy', on_error='ignore')
call_ivs = implied_vol(calls, S0, K, T, r, flag='c', q=0, return_as='numpy')
plt.plot(K, call_ivs, label=r'IV calls')
plt.plot(K, put_ivs, label=r'IV puts')
plt.ylabel('Implied Volatility')
plt.xlabel('Strike')
plt.title('Implied Volatility Smile from Heston Model')
plt.legend()
plt.show()
C:\Users\ASUS\anaconda3\lib\site-packages\py_vollib_vectorized\implied_volatility.py:75: UserWarning: Found Bel
ow Intrinsic contracts at index [0, 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15, 16, 17, 18, 19, 20, 21,
22, 23, 24, 25, 26, 27, 28, 29, 30]
below_intrinsic, above_max_price = _check_below_and_above_intrinsic(K, F, flag, undiscounted_option_price, on
_error)
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