CandleFocus

Heston Model

Candlefocus Editor
The Heston Model was first introduced in 1993 by economist Steven Heston as a way to more accurately price options, as the Black-Scholes model was not meeting that need. Heston's model assumed that the underlying asset's volatility is both arbitrary and non-constant, in contrast to the Black-Scholes Model which only assumed constant volatility.

The Heston Model is a stochastic volatility model based on the SDE of Heston's model. This SDE is composed of several stochastic variables and uses the Hull-White model. The Hull-White model is utilized to model the short rate as a process of variance. The stochastic states in this model are the spot price, the volatility and the short rate.

Each of these variables has a drift and a volatility, and they can be either correlated or independent. The model takes into account the correlation and volatility of each of the variables and factors that into the pricing of the option.

The output of the Heston Model is the price of the option at the current time. The Heston Model is used to price European and American, as well as exotic options. One of the main uses for the Heston Model is to calculate the implied volatility and the volatility surface of a given option.

The Heston Model is a powerful tool for traders, as it allows them to more accurately model and price options. This model is especially useful for options traders that are looking to profit from the volatility and movement of underlying assets. The Heston Model is used in numerous applications such as the pricing of options on bonds, foreign exchange, commodities and equities.

Glossary Index