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The Heston Model and its Extensions in Matlab and C#, + Website


Praise for The Heston Model and Its Extensions in Matlab and C#

"In his excellent new book, Fabrice Rouah provides a careful presentation of all aspects of the Heston model, with a strong emphasis on getting the model up and running in practice. This highly practical and useful book is recommended for anyone working with stochastic volatility models."
—Leif B. G. Andersen, Bank of America Merrill Lynch

"Without a doubt, Fabrice provides a very valuable contribution to quantitative analysts interested in pricing options with state-of-the art techniques."
—Marco Avellaneda, New York University

"The Heston model is one of the great success stories of academic finance. Rouah's impressive book provides users with all the tools required to implement the Heston model, and wonderfully bridges the gap between academia and practice."
—Peter Christoffersen, University of Toronto

"In this encyclopedic work, the author takes delight in exploring every aspect of the Heston model. Together with its included Matlab and C# code, this book will prove invaluable to anyone interested in option pricing. I highly recommend it."
—Jim Gatheral, Baruch College author of The Volatility Surface: A Practitioner's Guide

"This is the most extensive work on the Heston model I have seen: derivations, implementations, and discussions. For anyone interested in the Heston model and its variations, this is an important book to have!"
—Espen Gaarder Haug, Norwegian University of Life Sciences author of Derivatives Models on Models

"Rouah offers a unique and much needed synthesis of the literature regarding Heston's model of stochastic volatility. The author has accomplished the formidable task of presenting a large body of published academic and industrial research in a coherent, thorough, and very reader-friendly manner."
—Andrew Lesniewski, DTCC

"Beyond Black-Scholes, the Heston model is arguably the most important model in quantitative finance and certainly deserves its own book. Rouah provides here a comprehensive treatment—clearly discussing all the major issues, later extensions, and subtle traps."
—Alan L. Lewis, PhD, author of Option Valuation Under Stochastic Volatility: With Mathematica Code

FABRICE DOUGLAS ROUAH is a quantitative analyst who specializes in financial modeling of derivatives for pricing and risk management at Sapient Global Markets, a global consultancy. Prior to joining Sapient, Rouah worked at State Street Corporation and McGill University. He is the coauthor and/or coeditor of five books on hedge funds, commodity trading advisors, and option pricing. Rouah holds a PhD in finance and an MSc in statistics from McGill University, and a BSc in applied mathematics from Concordia University.

Foreword ix

Preface xi

Acknowledgments xiii

CHAPTER 1 The Heston Model for European Options 1

Model Dynamics 1

The European Call Price 4

The Heston PDE 5

Obtaining the Heston Characteristic Functions 10

Solving the Heston Riccati Equation 12

Dividend Yield and the Put Price 17

Consolidating the Integrals 18

Black-Scholes as a Special Case 19

Summary of the Call Price 22

Conclusion 23

CHAPTER 2 Integration Issues, Parameter Effects, and Variance Modeling 25

Remarks on the Characteristic Functions 25

Problems With the Integrand 29

The Little Heston Trap 31

Effect of the Heston Parameters 34

Variance Modeling in the Heston Model 43

Moment Explosions 56

Bounds on Implied Volatility Slope 57

Conclusion 61

CHAPTER 3 Derivations Using the Fourier Transform 63

The Fourier Transform 63

Recovery of Probabilities With Gil-Pelaez Fourier Inversion 65

Derivation of Gatheral (2006) 67

Attari (2004) Representation 69

Carr and Madan (1999) Representation 73

Bounds on the Carr-Madan Damping Factor and Optimal Value 76

The Carr-Madan Representation for Puts 82

The Representation for OTM Options 84

Conclusion 89

CHAPTER 4 The Fundamental Transform for Pricing Options 91

The Payoff Transform 91

The Fundamental Transform and the Option Price 92

The Fundamental Transform for the Heston Model 95

Option Prices Using Parseval’s Identity 100

Volatility of Volatility Series Expansion 108

Conclusion 113

CHAPTER 5 Numerical Integration Schemes 115

The Integrand in Numerical Integration 116

Newton-Cotes Formulas 116

Gaussian Quadrature 121

Integration Limits and Kahl and J ¨ ackel Transformation 130

Illustration of Numerical Integration 136

Fast Fourier Transform 137

Fractional Fast Fourier Transform 141

Conclusion 145

CHAPTER 6 Parameter Estimation 147

Estimation Using Loss Functions 147

Speeding up the Estimation 158

Differential Evolution 162

Maximum Likelihood Estimation 166

Risk-Neutral Density and Arbitrage-Free Volatility Surface 170

Conclusion 175

CHAPTER 7 Simulation in the Heston Model 177

General Setup 177

Euler Scheme 179

Milstein Scheme 181

Milstein Scheme for the Heston Model 183

Implicit Milstein Scheme 185

Transformed Volatility Scheme 188

Balanced, Pathwise, and IJK Schemes 191

Quadratic-Exponential Scheme 193

Alfonsi Scheme for the Variance 198

Moment Matching Scheme 201

Conclusion 202

CHAPTER 8 American Options 205

Least-Squares Monte Carlo 205

The Explicit Method 213

Beliaeva-Nawalkha Bivariate Tree 217

Medvedev-Scaillet Expansion 228

Chiarella and Ziogas American Call 253

Conclusion 261

CHAPTER 9 Time-Dependent Heston Models 263

Generalization of the Riccati Equation 263

Bivariate Characteristic Function 264

Linking the Bivariate CF and the General Riccati Equation 269

Mikhailov and No¨ gel Model 271

Elices Model 278

Benhamou-Miri-Gobet Model 285

Black-Scholes Derivatives 299

Conclusion 300

CHAPTER 10 Methods for Finite Differences 301

The PDE in Terms of an Operator 301

Building Grids 302

Finite Difference Approximation of Derivatives 303

The Weighted Method 306

Boundary Conditions for the PDE 315

Explicit Scheme 316

ADI Schemes 321

Conclusion 325

CHAPTER 11 The Heston Greeks 327

Analytic Expressions for European Greeks 327

Finite Differences for the Greeks 332

Numerical Implementation of the Greeks 333

Greeks Under the Attari and Carr-Madan Formulations 339

Greeks Under the Lewis Formulations 343

Greeks Using the FFT and FRFT 345

American Greeks Using Simulation 346

American Greeks Using the Explicit Method 349

American Greeks from Medvedev and Scaillet 352

Conclusion 354

CHAPTER 12 The Double Heston Model 357

Multi-Dimensional Feynman-KAC Theorem 357

Double Heston Call Price 358

Double Heston Greeks 363

Parameter Estimation 368

Simulation in the Double Heston Model 373

American Options in the Double Heston Model 380

Conclusion 382

Bibliography 383

About the Website 391

Index 397