DISTRIBUTION-BASED OPTION PRICING ON LATTICE ASSET DYNAMICS MODELS

Yuji Yamada () and James A. Primbs
Additional contact information
Yuji Yamada: Graduate School of Business Sciences, University of Tsukuba, 3-29-1 Otsuka, Bunkyo-ku, Tokyo 112-0012, Japan
James A. Primbs: Management Science and Engineering, Stanford University, Terman Engineering Center 700-327, CA 94305-4026, USA

International Journal of Theoretical and Applied Finance (IJTAF), 2002, vol. 05, issue 06, 599-618

Abstract: In this paper, we propose a numerical option pricing method based on an arbitrarily given stock distribution. We first formulate a European call option pricing problem as an optimal hedging problem by using a lattice based incomplete market model. A dynamic programming technique is then applied to solve the mean square optimal hedging problem for the discrete time multi-period case by assigning suitable probabilities on the lattice, where the underlying stock price distribution is derived directly from empirical stock price data which may possess "heavy tails". We show that these probabilities are obtained from a network flow optimization which can be solved efficiently by quadratic programming. A computational complexity analysis demonstrates that the number of iterations for dynamic programming and the number of parameters in the network flow optimization are both of square order with respect to the number of periods. Numerical experiments illustrate that our methodology generates the implied volatility smile.

Keywords: Incomplete markets; Lattice models; Minimum mean square hedges; Dynamic programming; Network flow optimization (search for similar items in EconPapers)
Date: 2002
References: Add references at CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://www.worldscientific.com/doi/abs/10.1142/S0219024902001572
Access to full text is restricted to subscribers

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wsi:ijtafx:v:05:y:2002:i:06:n:s0219024902001572

Ordering information: This journal article can be ordered from

DOI: 10.1142/S0219024902001572

Access Statistics for this article

International Journal of Theoretical and Applied Finance (IJTAF) is currently edited by L P Hughston

More articles in International Journal of Theoretical and Applied Finance (IJTAF) from World Scientific Publishing Co. Pte. Ltd.
Bibliographic data for series maintained by Tai Tone Lim ().