On the probability density function of baskets

DOI10.1007/978-3-319-11605-1_16MaRDI QIDQ4560341zbMATH OpenOpenAlexFDO

Authors Christian Bayer, Peter Friz, Peter Laurence

Publication date 11 December 2018

Published in Springer Proceedings in Mathematics & Statistics (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1306.2793

zbMATH Keywords

focalitypricing of butterfly spreads on basketssums of lognormals

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20) Large deviations (60F10)

Abstract: The state price density of a basket, even under uncorrelated Black-Scholes dynamics, does not allow for a closed from density. (This may be rephrased as statement on the sum of lognormals and is especially annoying for such are used most frequently in Financial and Actuarial Mathematics.) In this note we discuss short time and small volatility expansions, respectively. The method works for general multi-factor models with correlations and leads to the analysis of a system of ordinary (Hamiltonian) differential equations. Surprisingly perhaps, even in two asset Black-Scholes situation (with its flat geometry), the expansion can degenerate at a critical (basket) strike level; a phenomena which seems to have gone unnoticed in the literature to date. Explicit computations relate this to a phase transition from a unique to more than one "most-likely" paths (along which the diffusion, if suitably conditioned, concentrates in the afore-mentioned regimes). This also provides a (quantifiable) understanding of how precisely a presently out-of-money basket option may still end up in-the-money.

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Cited in

(5)

• Small-time asymptotics for basket options -- the bivariate SABR model and the hyperbolic heat kernel on \(\mathbb{H}^3\)
• A new concept of reliability system and applications in finance
• Reconstructing volatility: Pricing of index options under rough volatility
• Local Volatility, Conditioned Diffusions, and Varadhan's Formula
• Smoothing the payoff for efficient computation of Basket option prices

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