Pricing American options in the Heston model: A close look at incorporating correlation

We introduce a refined tree method to compute option prices using the stochastic volatility model of Heston. In a first step, we model the stock and variance process as two separate trees and with transition probabilities obtained by matching marginaltree moments up to order two against the Heston model ones. The correlation between the driving Brownian motions is then incorporated by a nodewise adjustment of the probabilities. This adjustment, leaving the marginals fixed, optimizes the match between tree and model correlation. In some nodes, we are even able to further match moments of higher order. Numerically, this gives convergence orders faster than 1/N, where N is the number of discretization steps. Accuracy of our method is checked for European option prices against a semiclosed form, and our prices for both European and American options are compared to alternative approaches.