Template-Type: ReDIF-Paper 1.0 Series: Tinbergen Institute Discussion Papers Creation-Date: 2006-05-18 Revision-Date: 2007-06-07 Number: 06-046/4 Author-Name: Roger Lord Author-Email: firstname.lastname@example.org Author-Workplace-Name: Erasmus Universiteit Rotterdam, and Rabobank Author-Name: Remmert Koekkoek Author-Email: email@example.com Author-Workplace-Name: Robeco Alternative Investments Author-Name: Dick van Dijk Author-Email: firstname.lastname@example.org Author-Workplace-Name: Faculty of Economics, Erasmus Universiteit Rotterdam Title: A Comparison of Biased Simulation Schemes for Stochastic Volatility Models Abstract: This discussion paper resulted in a publication in 'Quantitative Finance', 2010, 10, 177-194.
When using an Euler discretisation to simulate a mean-reverting square root process, one runs into the problem that while the process itself is guaranteed to be nonnegative, the discretisation is not. Although an exact and efficient simulation algorithm exists for this process, at present this is not the case for the Heston stochastic volatility model, where the variance is modelled as a square root process. Consequently, when using an Euler discretisation, one must carefully think about how to fix negative variances. Our contribution is threefold. Firstly, we unify all Euler fixes into a single general framework. Secondly, we introduce the new full truncation scheme, tailored to minimise the upward bias found when pricing European options. Thirdly and finally, we numerically compare all Euler fixes to a recent quasi-second order scheme of Kahl and Jäckel and the exact scheme of Broadie and Kaya. The choice of fix is found to be extremely important. The full truncation scheme by far outperforms all biased schemes in terms of bias, root-mean-squared error, and hence should be the preferred discretisation method for simulation of the Heston model and extensions thereof. Classification-JEL: C63; G13 Keywords: Stochastic volatility; Heston; square root process; Euler-Maruyama; discretisation; strong convergence; weak convergence; boundary behaviour File-Url: http://papers.tinbergen.nl/06046.pdf File-Format: application/pdf File-Size: 403673 bytes Handle: RePEc:tin:wpaper:20060046