Simulation of Stochastic Volatility using Path Integration: Smiles and Frowns

Abstract

We apply path integration techniques to obtain option pricing with stochastic volatility using a generalized Black-Scholes equation known as the Merton and Garman equation. We numerically simulate the option prices using the technique of path integration. Using market data, we determine the parameters of the model. It is found that the market chooses a special class of models for which a more efficient algorithm, called the bisection method, is applicable. Using our simulated data, we generate some implied volatility curves. We also analyze and study in detail some of the characteristics of the volatility curves within the model.