Pricing options on securities with discontinuous returns (Q1313131): Difference between revisions

The paper deals with a financial market with \(m+1\) security prices being traded continuously. One security is a risk-free asset. The other \(m\) securities are risky assets, called stocks, subject to the uncertainty in the market. The prices of the stocks are governed by linear stochastic differential equations driven by a multidimensional Brownian motion (representing the continuous flow of information into the market) and a multidimensional point process of random jumps with stochastic intensities (representing sudden shocks). The authors identify an equivalent risk-neutral probability measure (equivalent martingale measure approach), and apply it to the construction of hedging portfolios for European and American contingent claims, so to characterize the evolution of the price of a contingent claim over its lifetime. Finally, a differential-difference equation for the fair price of a derivative security is derived, that can be solved numerically to obtain option prices.