Multiplicative noise, fast convolution and pricing

Giacomo Bormetti and Sofia Cazzaniga

Quantitative Finance, 2014, vol. 14, issue 3, 481-494

Abstract: In this work we detail the application of a fast convolution algorithm to compute high-dimensional integrals in the context of multiplicative noise stochastic processes. The algorithm provides a numerical solution to the problem of characterizing conditional probability density functions at arbitrary times, and we apply it successfully to quadratic and piecewise linear diffusion processes. The ability to reproduce statistical features of financial return time series, such as thickness of the tails and scaling properties, makes these processes appealing for option pricing. Since exact analytical results are lacking, we exploit the fast convolution as a numerical method alternative to Monte Carlo simulation both in the objective and risk-neutral settings. In numerical sections we document how fast convolution outperforms Monte Carlo both in speed and efficiency terms.

Date: 2014
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DOI: 10.1080/14697688.2012.729857

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