Zhylyevskyy, Oleksandr

Review of Derivatives Research Vol. 13 no. 1 (March 11 2010): 1-24.

This paper develops a non-finite-difference-based method of American option pricing under stochastic volatility by extending the Geske-Johnson compound option scheme. The characteristic function of the underlying state vector is inverted to obtain the vector's density using a kernel-smoothed fast Fourier transform technique. The method produces option values that are closely in line with the values obtained by finite-difference schemes. It also performs well in an empirical application with traded S&P 100 index options. The method is especially well suited to price a set of options with different strikes on the same underlying asset, which is a task often encountered by practitioners.

JEL Classification: G00

Keywords: stochastic volatility, heston model, Geske-Johnson scheme, fast fourier transform, characteristic function inversion