Stock Option Price Computation under Economic Recession-Induced Stochastic Volatility Heston Model

Abstract

We present a model for an option pricing with economic recession-induced stochastic volatility in a univariate Heston setting. The recession-induced volatility concept of Bankole and Ugbebor is extended to the Heston model to account for uncertainty effect of recession on option returns on an underlying stock asset in a recessed economy. The model formulated is subject
to two economic states which allows regime switching based on the economic state under consideration. The characteristic function for the model is derived and subjected to fast Fourier transform method of Carr and Madan for option price computation. The numerical integration approximations based on Trapezoidal rule and Simpson’s rule is applied and simulation of the
model is carried out to obtain European-type call option prices. The option prices obtained following the assumptions and modifications incorporated, shows significant improvement on the existing Heston model especially with the economic recession parameters inclusion.