Pricing step options under the CEV and other solvable diffusion models

DOI10.1142/S0219024913500271zbMATH Open1282.91323arXiv1302.3771MaRDI QIDQ2853376FDOQ2853376

Authors: G. Campolieti, R. Makarov, K. Wouterloot 

Publication date: 21 October 2013

Published in: International Journal of Theoretical and Applied Finance (Search for Journal in Brave)

Abstract: We consider a special family of occupation-time derivatives, namely proportional step options introduced by Linetsky in [Math. Finance, 9, 55--96 (1999)]. We develop new closed-form spectral expansions for pricing such options under a class of nonlinear volatility diffusion processes which includes the constant-elasticity-of-variance (CEV) model as an example. In particular, we derive a general analytically exact expression for the resolvent kernel (i.e. Green's function) of such processes with killing at an exponential stopping time (independent of the process) of occupation above or below a fixed level. Moreover, we succeed in Laplace inverting the resolvent kernel and thereby derive newly closed-form spectral expansion formulae for the transition probability density of such processes with killing. The spectral expansion formulae are rapidly convergent and easy-to-implement as they are based simply on knowledge of a pair of fundamental solutions for an underlying solvable diffusion process. We apply the spectral expansion formulae to the pricing of proportional step options for four specific families of solvable nonlinear diffusion asset price models that include the CEV diffusion model and three other multi-parameter state-dependent local volatility confluent hypergeometric diffusion processes.

Full work available at URL: https://arxiv.org/abs/1302.3771

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zbMATH Keywords

option pricingGreen's functionsspectral expansionLaplace transform inversionstep optionsexponential stopping timesoccupation time optionssolvable diffusions

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20) Numerical methods (including Monte Carlo methods) (91G60) Diffusion processes (60J60)

Cites Work

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Cited In (8)

• Pricing Options on Scalar Diffusions: An Eigenfunction Expansion Approach
• Geometric step options and Lévy models: duality, pides, and semi-analytical pricing
• Solvable Diffusion Models with Linear and Mean-Reverting Nonlinear Drifts
• Occupation times of hyper-exponential jump diffusion processes with application to price step options
• THE SPECTRAL DECOMPOSITION OF THE OPTION VALUE
• American step options
• Occupation times of Lévy-driven Ornstein-Uhlenbeck processes with two-sided exponential jumps and applications
• Pricing and Hedging Path-Dependent Options Under the CEV Process

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