Option Pricing in Illiquid Markets with Jumps

José M. T. S. Cruz and Daniel Ševčovič

Applied Mathematical Finance, 2018, vol. 25, issue 4, 389-409

Abstract: The classical linear Black–Scholes model for pricing derivative securities is a popular model in the financial industry. It relies on several restrictive assumptions such as completeness, and frictionless of the market as well as the assumption on the underlying asset price dynamics following a geometric Brownian motion. The main purpose of this paper is to generalize the classical Black–Scholes model for pricing derivative securities by taking into account feedback effects due to an influence of a large trader on the underlying asset price dynamics exhibiting random jumps. The assumption that an investor can trade large amounts of assets without affecting the underlying asset price itself is usually not satisfied, especially in illiquid markets. We generalize the Frey–Stremme nonlinear option pricing model for the case the underlying asset follows a Lévy stochastic process with jumps. We derive and analyze a fully nonlinear parabolic partial-integro differential equation for the price of the option contract. We propose a semi-implicit numerical discretization scheme and perform various numerical experiments showing the influence of a large trader and intensity of jumps on the option price.

Date: 2018
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DOI: 10.1080/1350486X.2019.1585267

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