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Option pricing in a sentiment-biased stochastic volatility model

Author

Listed:
  • Alessandra Cretarola

    (University of Perugia)

  • Gianna Figà-Talamanca

    (University of Perugia)

  • Marco Patacca

    (University of Perugia)

Abstract

This paper presents a Markov-modulated stochastic volatility model that captures the dependency of market regimes on investor sentiment. The main contribution lies in developing a modified version of the classical Heston model by allowing for a sentiment-driven bias in the volatility of the asset. Specifically, a two-factor Markov-modulated stochastic volatility model is proposed, integrating a diffusion coefficient in the risky asset dynamics and a correlation parameter influenced by both the volatility process and a continuous-time Markov chain accounting for the sentiment-bias. Diverging from conventional approaches in option pricing models, this framework operates under the real-world probability measure, necessitating considerations about the existence of an equivalent martingale pricing measure. The purpose of this paper is to derive a closed formula for the pricing of European-style derivatives and to fit the model on market data through a suitable calibration procedure. A comparison with the Heston benchmark model is provided for a sample of Apple, Amazon, and Bank of America stock options.

Suggested Citation

  • Alessandra Cretarola & Gianna Figà-Talamanca & Marco Patacca, 2025. "Option pricing in a sentiment-biased stochastic volatility model," Annals of Finance, Springer, vol. 21(1), pages 69-95, March.
    • Handle: RePEc:kap:annfin:v:21:y:2025:i:1:d:10.1007_s10436-024-00448-3
    DOI: 10.1007/s10436-024-00448-3
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    More about this item

    Keywords

    Stochastic volatility; Regime-switching; Sentiment analysis; Option pricing;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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