High-order approximations to call option prices in the Heston model

Abstract

In the present paper, a decomposition formula for the call price due to Alòs is transformed into a Taylor-type formula containing an infinite series with stochastic terms. The new decomposition may be considered as an alternative to the decomposition of the call price found in a recent paper by Alòs, Gatheral and Rodoičić. We use the new decomposition to obtain various approximations to the call price in the Heston model with sharper estimates of the error term than in previously known approximations. One of the formulas obtained in the present paper has five significant terms and an error estimate of the form $O\left(\nu^3(|\rho|+\nu)\right)$, where $v$ and $\rho$ are the volatility-of-volatility and the correlation in the Heston model, respectively. Another approximation formula contains seven more terms and the error estimate is of the form $O\left(v^4(1+|\rho| v)\right)$. For the uncorrelated Heston model $(\rho=0)$, we obtain a formula with four significant terms and an error estimate $O\left(v^6\right)$. Numerical experiments show that the new approximations to the call price perform especially well in the high-volatility mode.