Adaptive continuous time Markov chain approximation model to general jump-diffusions

Mario Cerrato, Chia Chun Lo and Konstantinos Skindilias

Working Papers from Business School - Economics, University of Glasgow

Abstract: We propose a non-equidistant Q rate matrix formula and an adaptive numerical algorithm for a continuous time Markov chain to approximate jump-diffusions with affine or non-affine functional specifications. Our approach also accommodates state-dependent jump intensity and jump distribution, a flexibility that is very hard to achieve with other numerical methods. The Kolmogorov-Smirnov test shows that the proposed Markov chain transition density converges to the one given by the likelihood expansion formula as in Ait-Sahalia (2008). We provide numerical examples for European stock option pricing in Black and Scholes (1973), Merton (1976) and Kou (2002).

Keywords: Markov Chains; Diffusion Approximation; Transition Density; Jump-Diffusion Approximation; Option Pricing (search for similar items in EconPapers)
JEL-codes: C60 G10 G12 G13 (search for similar items in EconPapers)
Date: 2011-06
New Economics Papers: this item is included in nep-ore
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Citations: View citations in EconPapers (1)

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