Physics and Derivatives: Effective-Potential Path-Integral Approximations of Arrow-Debreu Densities

Luca Capriotti and Ruggero Vaia

Papers from arXiv.org

Abstract: We show how effective-potential path-integrals methods, stemming on a simple and nice idea originally due to Feynman and successfully employed in Physics for a variety of quantum thermodynamics applications, can be used to develop an accurate and easy-to-compute semi-analytical approximation of transition probabilities and Arrow-Debreu densities for arbitrary diffusions. We illustrate the accuracy of the method by presenting results for the Black-Karasinski and the GARCH linear models, for which the proposed approximation provides remarkably accurate results, even in regimes of high volatility, and for multi-year time horizons. The accuracy and the computational efficiency of the proposed approximation makes it a viable alternative to fully numerical schemes for a variety of derivatives pricing applications.

Date: 2019-02
New Economics Papers: this item is included in nep-cmp
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Published in Journal of Derivatives 28, 8-25 (2020)

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Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:1902.03610

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