EXPANSION FORMULAS FOR BIVARIATE PAYOFFS WITH APPLICATION TO BEST-OF OPTIONS ON EQUITY AND INFLATION

Emmanuel Gobet () and Julien Hok ()
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Emmanuel Gobet: Centre de Mathématiques Appliquées, Ecole Polytechnique and CNRS, Route de Saclay, 91128 Palaiseau Cedex, France
Julien Hok: Markit, Ropemaker Place 25 Ropemaker Street, London, EC2Y 9LY, United Kingdom

International Journal of Theoretical and Applied Finance (IJTAF), 2014, vol. 17, issue 02, 1-32

Abstract: A wide class of hybrid products are evaluated with a model where one of the underlying price follows a local volatility diffusion and the other asset value a log-normal process. Because of the generality for the local volatility function, the numerical pricing is usually much time consuming. Using proxy approximations related to log-normal modeling, we derive approximation formulas of Black–Scholes type for the price, that have the advantage of giving very rapid numerical procedures. This derivation is illustrated with the best-of option between equity and inflation where the stock price follows a local volatility model and the inflation rate a Hull–White process. The approximations possibly account for Gaussian HJM (Heath-Jarrow-Morton) models for interest rates. The experiments show an excellent accuracy.

Keywords: Hybrid derivatives; best-of options; inflation derivatives; local volatility model; expansion formula; closed-form solutions (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (4)

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DOI: 10.1142/S0219024914500101

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