Heston's paper (1993) presents a method to
derive a closed-form solution for derivatives pricing when the
volatility of the underlying asset follows a stochastic dynamics. His
approach is appropriate for European derivatives but, unfortunately,
does not provide a formula to price more complex contracts. In this
paper we propose an alternative stochastic volatility model which
retains many features of Heston's model and is suitable for an
easy discretization through recombining trees in the spirit of Nelson
and Ramaswamy (1990). After having discussed the theoretical properties
of the model we construct its discretized counterpart through a
recombining multinomial tree. We apply the model to the USD/EURO
exchange rate market, evaluating both American and barrier options.
