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1) Gatheral expresses everything in forward terms: forward value of the spot and of the call. Consider an asset $A$. You need to hold $A$ at time $T$ but since you don't need it now you don't want to buy it now. Instead you enter a forward contract with someone that says that at time $T$ you will pay the amount $K$ and get the asset in exchange. What ...


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There is a qualitative shift in the shape of the density. When V is small it is monotone decaying. When V is large it looks more like a Gaussian. Another reason he uses two schemes is that he wants match two moments of the density. When V is small, the moment matching equations for the quadratic Gaussian are unsolvable. When V is large they are unsolvable ...


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The Feller condition applies without modification. That is under the assumption that $v$ is square-root process with poisson-arrival jumps (as you wrote), and assuming the jump distribution is strictly positive and initial level $v_0>0$. The reason is, conditional on no jumps occuring, the process is just a square root process, for which the references ...


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There are by now a lot of papers on discretizations of Heston. One objective of them being to avoid negativity. As has already been said, the Heston SDE has no negative solutions, but a crude discretization does give negative variance with positive probability. If you want to do small steps, then using a log-normal approximation or the QE approximation ...


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Look at the B-S parameters for the dynamics of the stock. $\frac{dS}{S} = \mu dt + \sigma dt$ $\sigma$ is independent of strike in the B-S model, which means all derivatives priced assuming these dynamics should have the same volatility. This clearly is not the case given the existence of smile and skew. You can't assume the BS model produces the "fair" ...


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Intuition: You can think of the vol smile as a reflection of the risk neutral distribution (compared to the Black Scholes Gaussian density). A fat tailed distribution creates the smile: fat tail -> higher prob of exercise than Gaussian with constant stdev -> higher option price than BS with ATM vol -> higher implied vol for given strike. Skewed distributions ...


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Some simple improvements: 1) Replace the Euler discretization approximation of the volatility to a Milstein discretization approximation. See e.g. these notes by Rouah. 2) 100 Paths is a very low number of paths, and leads to a big standard error in your estimate. So this should be increased by a factor of ~100. 3) You should use some form of variance ...


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change the discretization and use the QE-M approach: Andersen (2006) the bias is way smaller than the one of the simple Euler. further u can try to use control variates/anthitetic numbers to reduce the sample variance.


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Heston gives an expression for the characteristic function, from which option prices can be computed. Therefore it can be calibrated (statically) on a set of vanilla option prices with different strikes and maturities. Hence this produces risk neutral parameters that can be used to price other more exotic products. However, it is a pain to estimate the ...


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The issue I have with these approaches is that they use the unconditional distribution to eliminate the latent volatility. However, when the volatility process has very weak mean reversion one would need a very long and clean sample to make robust parameter identification from the unconditional density. They just throw away all the information from the ...


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Gatheral (Amazon) has a quite extensive discussion on that, and dives into calibration issues. In summary, what you describe appears to be less of a modeling issue, and more of a calibration problem. This is primarily because the model functions (such as the Heston model) are not by nature convex in their input parameters. This is simply result of the fact ...


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Yes! Try this and this. But if you don't know the black-scholes basics well consider to read the book "Paul Wilmott in Quantitative Finance" before to go to Stochastic Volatility models and models with jumps.



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