A closed-form approximation to European option prices under a multifactor extension of Heston's stochastic volatility model

In this study, we extend the multi-scale stochastic volatility model of [Fouque and Lorig, SIAM J. Finan. Math., 2011] by incorporating a slow varying factor of volatility.  Asymptotic analysis is developed to obtain an... [ view full abstract ]

In this study, we extend the multi-scale stochastic volatility model of [Fouque and Lorig, SIAM J. Finan. Math., 2011] by incorporating a slow varying factor of volatility.  Asymptotic analysis is developed to obtain an explicit approximation for European option prices. An accuracy result of the asymptotic approximation is also provided. For numerical illustration, our model is calibrated to index options on the market, and we find that the resulting implied volatility surfaces fit the market data much better than those produced by the multi-scale stochastic volatility model of [Fouque and Lorig, SIAM J. Finan. Math., 2011] for long-term call options.