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A Stochastic Correlation Model with Mean Reversion for Pricing Multi-Asset Options

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Abstract

We set up a new kind of model to price the multi-asset options. A square root process fluctuating around its mean value is introduced to describe the random evolution of correlation between two assets. In this stochastic correlation model with mean reversion term, the correlation is a random walk within the region from −1 to 1, and it is centered around its equilibrium value. The trading strategy to hedge the correlation risk is discussed. Since a solution of high-dimensional partial differential equation may be impossible, the Quasi-Monte Carlo and Monte Carlo methods are introduced to compute the multi-asset option price as well. Taking a better-of two asset rainbow as an example, we compare our results with the price obtained by the Black–Scholes model with constant correlation.

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Authors and Affiliations

  1. Temasek Laboratories, National University of Singapore, 5, Sport Drive 2, Singapore, 117508, Singapore

    Jun Ma

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  1. Jun Ma
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Correspondence to Jun Ma.

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Ma, J. A Stochastic Correlation Model with Mean Reversion for Pricing Multi-Asset Options. Asia-Pac Financ Markets 16, 97–109 (2009). https://doi.org/10.1007/s10690-009-9088-2

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  • DOI: https://doi.org/10.1007/s10690-009-9088-2

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