Modular pricing of options. An application of Fourier analysis (Q1582802)

As it is well-known, Black-Scholes framework is too restrictive in many circumstances. Nowadays, option pricing theory is undergoing a significant technical innovation: Fourier analysis and characteristic functions, which are successfully applied to stochastic volatility models. This class of models is suggested to capture the leptokurtic property of empirical distributions of stock returns, a property that is not consistent with the normal distribution in the Black-Scholes model. The author constructs so called ``Modular Pricing of Options'' (MPO), that includes different versions of such stochastic factors as interest rates, volatilities and jumps. For example, he considers three volatility models with closed-form solutions of options: square-root (SR) process, Ornstein-Uhlenbeck (O-U) process and Double Square-Root (DSR) process. Possible interest rates include deterministic case, SR, O-U and DSR processes; jumps are classified to pure, lognormal and Pareto jumps. As to organization of the book, Chapter 1 deals with general financial and mathematical background of Fourier analysis, that includes constructing characteristic functions (CF) in an option pricing environment, interpreting CF from the point of view of completing security markets via options and connecting Fourier analysis with the traditional valuation method. In Chapter 2, the valuation framework of MPO is discussed in details according to stochastic factors mentioned above. In most the cases, the closed-form pricing formula is given by applying the Fourier inversion to the CF of the form \(\mathbb E [\exp(i\phi\ln S(T))]\) that can be calculated directly. Chapter 3 focuses on how to extend MPO approach for exotic options: barrier options, lookback and Asian options, exchange, quotient and product options. Chapter 4 gives some conclusions.