Higher order approximation of call option prices under stochastic volatility models

Abstract

In the present paper, a decomposition formula for the call price due to Al\`{o}s 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 of Al\`{o}s, Gatheral and Radoi\v{c}i\'{c}. 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 the previously known approximations. One of the formulas obtained in the present paper has five significant terms and an error estimate of the form $O(\nu^{3}(\left|\rho\right|+\nu))$, where $\nu$ is the vol-vol parameter, and $\rho$ is the correlation coefficient between the price and the volatility in the Heston model. Another approximation formula contains seven more terms and the error estimate is of the form $O(\nu^4(1+|\rho|)$. For the uncorrelated Hestom model ($\rho=0$), we obtain a formula with four significant terms and an error estimate $O(\nu^6)$. Numerical experiments show that the new approximations to the call price perform especially well in the high volatility mode.