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A Spanning Series Approach to Options

Steven L. Heston and Alberto G. Rossi

The Review of Asset Pricing Studies, 2017, vol. 7, issue 1, 2-42

Abstract: This paper shows that Edgeworth expansions for option valuation are equivalent to approximating option payoffs using Hermite polynomials. Consequently, the value of an option is the value of an infinite series of replicating polynomials. The resultant formulas express option values in terms of skewness, kurtosis, and higher moments. Unfortunately, the Hermite series diverges for fat-tailed models, so we provide alternative moment-based formulas. These formulas are a computationally efficient alternative to Fourier transform valuation and can value options even when the characteristic function is unknown. Applications include the first convergent solution for Hull and White’s stochastic volatility model.Received February 1, 2016; accepted June 27, 2016 by Editor Wayne Ferson.

JEL-codes: G12 (search for similar items in EconPapers)
Date: 2017
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