Valuation of asset and volatility derivatives using decoupled time-changed Lévy processes

DOI10.1007/S11147-015-9113-8zbMATH Open1345.91075arXiv1210.5479OpenAlexW875885787MaRDI QIDQ315041FDOQ315041

Authors: Lorenzo Torricelli 

Publication date: 19 September 2016

Published in: Review of Derivatives Research (Search for Journal in Brave)

Abstract: In this paper we propose a general derivative pricing framework which employs decoupled time-changed (DTC) L'evy processes to model the underlying asset of contingent claims. A DTC L'evy process is a generalized time-changed L'evy process whose continuous and pure jump parts are allowed to follow separate random time scalings; we devise the martingale structure for a DTC L'evy-driven asset and revisit many popular models which fall under this framework. Postulating different time changes for the underlying L'evy decomposition allows to introduce asset price models consistent with the assumption of a correlated pair of continuous and jump market activities; we study one illustrative DTC model having this property by assuming that the instantaneous activity rates follow the the so-called Wishart process. The theory developed is applied to the problem of pricing claims depending not only on the price or the volatility of an underlying asset, but also to more sophisticated derivatives that pay-off on the joint performance of these two financial variables, like the target volatility option (TVO). We solve the pricing problem through a Fourier-inversion method; numerical computations validating our technique are provided.

Full work available at URL: https://arxiv.org/abs/1210.5479

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zbMATH Keywords

derivative pricingjoint asset and volatility derivativestarget volatility optiontime changesWishart processLévy processes

Mathematics Subject Classification ID

Processes with independent increments; Lévy processes (60G51) Derivative securities (option pricing, hedging, etc.) (91G20) Martingales with continuous parameter (60G44)

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Cited In (3)

• FFT-network for bivariate Lévy option pricing
• Financial modelling applying multivariate Lévy processes: new insights into estimation and simulation
• Valuation of volatility derivatives with time-varying volatility: an analytical probabilistic approach using a mixture distribution for pricing nonlinear payoff volatility derivatives in discrete observation case

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