EconPapers    
Economics at your fingertips  
 

Option pricing with Legendre polynomials

Julien Hok and Tat Lung Chan

Papers from arXiv.org

Abstract: Here we develop an option pricing method based on Legendre series expansion of the density function. The key insight, relying on the close relation of the characteristic function with the series coefficients, allows to recover the density function rapidly and accurately. Based on this representation for the density function, approximations formulas for pricing European type options are derived. To obtain highly accurate result for European call option, the implementation involves integrating high degree Legendre polynomials against exponential function. Some numerical instabilities arise because of serious subtractive cancellations in its formulation (96) in proposition 7.1. To overcome this difficulty, we rewrite this quantity as solution of a second-order linear difference equation and solve it using a robust and stable algorithm from Olver. Derivation of the pricing method has been accompanied by an error analysis. Errors bounds have been derived and the study relies more on smoothness properties which are not provided by the payoff? functions, but rather by the density function of the underlying stochastic models. This is particularly relevant for options pricing where the payoff of the contract are generally not smooth functions. The numerical experiments on a class of models widely used in quantitative finance show exponential convergence.

Date: 2016-10, Revised 2017-03
References: View references in EconPapers View complete reference list from CitEc
Citations View citations in EconPapers (1) Track citations by RSS feed

Downloads: (external link)
http://arxiv.org/pdf/1610.03086 Latest version (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:1610.03086

Access Statistics for this paper

More papers in Papers from arXiv.org
Series data maintained by arXiv administrators ().

 
Page updated 2017-12-02
Handle: RePEc:arx:papers:1610.03086