Pricing the European call option in the model with stochastic volatility driven by Ornstein--Uhlenbeck process. Exact formulas

TL;DR

This paper derives exact formulas for pricing European call options in a modified Black--Scholes model with stochastic volatility driven by an Ornstein--Uhlenbeck process, using inverse Fourier transforms and Gaussian properties.

Contribution

It introduces an analytic formula for European call options in a stochastic volatility model with Ornstein--Uhlenbeck process, expanding the analytical tools in option pricing.

Findings

Derived explicit pricing formulas for European call options.

Established the existence of an equivalent martingale measure.

Utilized inverse Fourier transform and Gaussian properties for calculations.

Abstract

We consider the Black--Scholes model of financial market modified to capture the stochastic nature of volatility observed at real financial markets. For volatility driven by the Ornstein--Uhlenbeck process, we establish the existence of equivalent martingale measure in the market model. The option is priced with respect to the minimal martingale measure for the case of uncorrelated processes of volatility and asset price, and an analytic expression for the price of European call option is derived. We use the inverse Fourier transform of a characteristic function and the Gaussian property of the Ornstein--Uhlenbeck process.