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Closed-form approximations in derivatives pricing: The Kristensen-Mele approach

Michael Kurz

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Abstract: Kristensen and Mele (2011) developed a new approach to obtain closed-form approximations to continuous-time derivatives pricing models. The approach uses a power series expansion of the pricing bias between an intractable model and some known auxiliary model. Since the resulting approximation formula has closed-form it is straightforward to obtain approximations of greeks. In this thesis I will introduce Kristensen and Mele's methods and apply it to a variety of stochastic volatility models of European style options as well as a model for commodity futures. The focus of this thesis is the effect of different model choices and different model parameter values on the numerical stability of Kristensen and Mele's approximation.

Date: 2018-04
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Handle: RePEc:arx:papers:1804.08904