Option Pricing Under a Mixed-Exponential Jump Diffusion Model

Ning Cai () and S. G. Kou ()
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Ning Cai: Department of Industrial Engineering and Logistics Management, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong
S. G. Kou: Department of Industrial Engineering and Operations Research, Columbia University, New York, New York 10027

Management Science, 2011, vol. 57, issue 11, 2067-2081

Abstract: This paper aims to extend the analytical tractability of the Black-Scholes model to alternative models with arbitrary jump size distributions. More precisely, we propose a jump diffusion model for asset prices whose jump sizes have a mixed-exponential distribution, which is a weighted average of exponential distributions but with possibly negative weights. The new model extends existing models, such as hyperexponential and double-exponential jump diffusion models, because the mixed-exponential distribution can approximate any distribution as closely as possible, including the normal distribution and various heavy-tailed distributions. The mixed-exponential jump diffusion model can lead to analytical solutions for Laplace transforms of prices and sensitivity parameters for path-dependent options such as lookback and barrier options. The Laplace transforms can be inverted via the Euler inversion algorithm. Numerical experiments indicate that the formulae are easy to implement and accurate. The analytical solutions are made possible mainly because we solve a high-order integro-differential equation explicitly. A calibration example for SPY options shows that the model can provide a reasonable fit even for options with very short maturity, such as one day. This paper was accepted by Michael Fu, stochastic models and simulation.

Keywords: jump diffusion; mixed-exponential distributions; lookback options; barrier options; Merton's normal jump diffusion model; first passage times (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (78)

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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:57:y:2011:i:11:p:2067-2081

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