What is the Heston model?
The Heston model is a method of valuation of options that take into account volatility changes that are observed across different options traded at a given time for the same asset. It attempts to re -create prices on the market using stochastic processes to model volatility and interest rates. The Heston model is characterized by the inclusion of the square root of the volatility function in the total price function. He proposed a model that in his contribution of 1993 took over his name "The solution of a closed form for the possibilities with stochastic volatility with applications on Bond and currency options," published in the review of financial studies . The contribution examined the European election prices.
options derive their values from the expected value of the profit that the option holder can realize, depending on the price and volatility of the underlying asset. Many options with different strike prices can be based on the same underlying asset. Theoretically volatility that the price of each option indicates should be between these possibleThe same is the same because they are all based on the same asset. Some prices of options, such as Black-Scholes, create this assumption and use the predicted volatility of the asset to predict the price of options with any strike price; Others, such as the Heston model, the volatility of the first model and then draw the conclusions of the prices.
In practice, however, volatility, which means price, differs according to the characteristics of the possibilities - specifically according to the strike price. The central possibility is that with a strike price equal to the current market, it is likely to be the basis of stocks. This is also called the possibility of AT-Money. As the strike price moves away from the market price, volatility changes. Analysts create charts called volatility chamfered charts of this relationship and, according to their shapes, give chart names such as a smile of volatility.
Price models should predict prices that products with the characteristics will require on the market. If the market returns different prices than expected, the model must be updated. StochasTical volatility is a method of modeling volatility variations. The Heston model is one of the ways to model the price of asset to obtain trends in the expected volatility observed on the markets with stochastic processes. It is one of the most commonly used models based on stochastic volatility.