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 closedform solution for pricing options that seeks to overcome the shortcomings in the BlackScholes option pricing model related to return skewness and strikeprice 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 inthemoney or outofthemoney. The smile model's name derives from the concave shape of the graph, which resembles a smile.

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