Parisian option pricing: a recursive solution for the density of the Parisian stopping time (Q2873142)

Parisian options are path-dependent options whose payoff depends on the final value of the underlying asset and on the path trajectory of the underlying asset. There is no explicit pricing formula for this type of options.NEWLINENEWLINEIn the present paper the density function of the single barrier one-side Parisian stopping time is obtained. The developed method reduces to that of solving a Volterra integral equation, and a recursive solution is consequently obtained. The advantage of this method, as compared to the previous known methods, is that the recursions are easy to program.NEWLINENEWLINEIn the introduction of the paper a brief review of Parisian options is presented. The classical approach using the Laplace transform is discussed.NEWLINENEWLINEIn Section 2, the definitions, assumptions and notations are introduced. Here \(S\) is an underlying asset which follows a geometric Brownian motion and \(Q\) denotes the risk neutral probability measure. The underlying asset \(S\) is given as a solution of the differential equation \(d S_t = S_t(r dt + \sigma d W_t),\) \(S_0 = x,\) where \(W_t\) is a standard Brownian motion under \(Q\), and \(r\) and \(\sigma\) are positive parameters. The notations for the stopping times \(\tau_b^+\) and \(\tau_b^-\) are introduced. The price \(C_i^d(x,T)\) of the Parisian down-and-in call is defined.NEWLINENEWLINEIn Section 3, the main results of the paper are presented. In Theorem 3.1, an explicit formula in a recursive form for the probability density function \(f_b^-(t)\) of the measure \(\tau_b^-,\) in the case when the parameter \(b \leq 0,\) is given. The proof is realized in two steps. The first step is an intuitive proof for \(1 < t < 3\) and the second step is the general case when \(b \leq 0.\) In Theorem 3.2, in the case when the parameter \(b\) is positive, an explicit formula in a recursive form for the probability density function \(f_b^-(t)\) of the measure \(\tau_b^-\) on the set \(\{T_b < 1\}\) is given.NEWLINENEWLINEIn Section 4, applications of the results on the pricing of Parisian options are presented. In Theorem 4.1, in the case when \(b < 0,\) a formula in explicit form for the price of a down-and-in Parisian option on the underlying \(S\) with barrier \(L < x\) and a maturity time \(T > 1\) is given. In Theorem 4.2, a formula for the price of a down-and-in Parisian option is obtained in the case when \(b > 0\).NEWLINENEWLINEIn Section 5, the code in R for the calculation of the density functions is presented. A comparison of the CPU time for the authors' algorithm and algorithms which use the Laplace inversion technique is given. Also the prices of a Parisian down-and-in call of different examples are presented.