A volatility measure which is premised on “time-varying” volatility and factors’ co-dependency. In other words, the underlying volatility and mutual relationships among key variables are allowed, as opposed to Black-Scholes assumptions, to fluctuate over time rather than remain stationary.

The Black-Scholes (B&S) model assumes that the underlying stock price follows a geometric Brownian motion with constant volatility and interest rates. But volatility, in the real world, does vary over time and is assumed to be driven by a stochastic process. Options with different strikes and expiration dates have different implied volatilities, as extracted using the B&S model. Furthermore, the prices of exotic options given by the B&S model can be widely off the mark because of their higher sensitivity to levels of volatility in comparison with standard vanilla options. In this respect, stochastic volatility provides a basis for more realistic modeling of option prices.

It is also known as Heston volatility.