A General Computation Scheme for a High-Order Asymptotic Expansion Method

Akihiko Takahashi, Kohta Takehara and Masashi Toda
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Akihiko Takahashi: Faculty of Economics, University of Tokyo
Kohta Takehara: Graduate School of Economics, University of Tokyo
Masashi Toda: Graduate School of Economics, University of Tokyo

No CARF-F-242, CARF F-Series from Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo

Abstract: This paper presents a new computational scheme for an asymptotic expansion method of an arbitrary order. The asymptotic expansion method in finance initiated by Kunitomo and Takahashi [9], Yoshida [34] and Takahashi [20], [21] is a widely applicable methodology for an analytic approximation of expectation of a certain functional of diffusion processes. Hence, not only academic researchers but also many practitioners have used the methodology for a variety of financial issues such as pricing or hedging complex derivatives under high-dimensional underlying stochastic environments. In practical applications of the expansion, a crucial step is calculation of conditional expectations for a certain kind of Wiener functionals. [20], [21] and Takahashi and Takehara [23] provided explicit formulas for those conditional expectations necessary for the asymptotic expansion up to the third order. This paper presents the new method for computing an arbitrary-order expansion in a general diffusion-type stochastic environment, which is powerful especially for high-order expansions: We develops a new calculation algorithm for computing coefficients of the expansion through solving a system of ordinary differential equations that is equivalent to computing the conditional expectations directly. To demonstrate its effectiveness, the paper gives numerical examples of the approximation for a ă-SABR model up to the fifth order and a cross-currency Libor market model with a general stochastic volatility model of the spot foreign exchange rate up to the fourth order.

Pages: 26 pages
Date: 2011-02, Revised 2011-07
New Economics Papers: this item is included in nep-cmp
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Citations: View citations in EconPapers (18)

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