DEFINITION of 'Heston Model'

A type of stochastic volatility model developed by associate finance professor Steven Heston in 1993 for analyzing bond and currency options. The Heston model is a closed-form solution for pricing options that seeks to overcome the shortcomings in the Black-Scholes option pricing model related to return skewness and strike-price bias. The Heston model is a tool for advanced investors.

BREAKING DOWN 'Heston Model'

Stochastic volatility models use statistical methods to calculate and forecast options pricing. They are based on the assumption that the volatility of the underlying security is arbitrary. Other types of stochastic volatility models include the SABR model, the Chen model and the GARCH model. The Heston model is also a type of standard smile model. "Smile" refers to the volatility smile, a graphical representation of several options with identical expiration dates that shows increasing volatility as the options become more in-the-money or out-of-the-money. The smile model's name derives from the concave shape of the graph, which resembles a smile.

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