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On the Solution of the Multi-asset Black-Scholes model: Correlations, Eigenvalues and Geometry

Mauricio Contreras, Alejandro Llanquihu\'en and Marcelo Villena

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Abstract: In this paper, we study the multi-asset Black-Scholes model in terms of the importance that the correlation parameter space (equivalent to an $N$ dimensional hypercube) has in the solution of the pricing problem. We show that inside of this hypercube there is a surface, called the Kummer surface $\Sigma_K$, where the determinant of the correlation matrix $\rho$ is zero, so the usual formula for the propagator of the $N$ asset Black-Scholes equation is no longer valid. Worse than that, in some regions outside this surface, the determinant of $\rho$ becomes negative, so the usual propagator becomes complex and divergent. Thus the option pricing model is not well defined for these regions outside $\Sigma_K$. On the Kummer surface instead, the rank of the $\rho$ matrix is a variable number. By using the Wei-Norman theorem, we compute the propagator over the variable rank surface $\Sigma_K$ for the general $N$ asset case. We also study in detail the three assets case and its implied geometry along the Kummer surface.

Date: 2015-10
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