REPLICATION SCHEME FOR THE PRICING OF EUROPEAN OPTIONS

Hideharu Funahashi ()
Additional contact information
Hideharu Funahashi: Faculty of Economics, Kanagawa University, 3-27-1 Rokkakubashi, Kanagawa-ku, Yokohama-shi, Kanagawa 221-8686, Japan

International Journal of Theoretical and Applied Finance (IJTAF), 2021, vol. 24, issue 03, 1-37

Abstract: This paper proposes an efficient method for calculating European option prices under local, stochastic, and fractional volatility models. Instead of directly calculating the density function of a target underlying asset, we replicate it from a simpler diffusion process with a known analytical solution for the European option. For this purpose, we derive six functions that characterize the density function of a diffusion process, for both the original and simpler processes and match these functions so that the latter mimics the former. Using the analytical formula, we then approximate the option price of the target asset. By comparison with previous works and numerical experiments, we show that the accuracy of our approximation is high, and the calculation is fast enough for practical purposes; hence, it is suitable for calibration purposes.

Keywords: Local volatility model; stochastic volatility model; fractional volatility model; chaos expansion; density matching; calibration (search for similar items in EconPapers)
Date: 2021
References: Add references at CitEc
Citations:

Downloads: (external link)
http://www.worldscientific.com/doi/abs/10.1142/S021902492150014X
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:24:y:2021:i:03:n:s021902492150014x

Ordering information: This journal article can be ordered from

DOI: 10.1142/S021902492150014X

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 ().