Pricing derivatives on multiscale diffusions: an eigenfunction expansion approach
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Abstract: Using tools from spectral analysis, singular and regular perturbation theory, we develop a systematic method for analytically computing the approximate price of a derivative-asset. The payoff of the derivative-asset may be path-dependent. Additionally, the process underlying the derivative may exhibit killing (i.e. jump to default) as well as combined local/nonlocal stochastic volatility. The nonlocal component of volatility is multiscale, in the sense that it is driven by one fast-varying and one slow-varying factor. The flexibility of our modeling framework is contrasted by the simplicity of our method. We reduce the derivative pricing problem to that of solving a single eigenvalue equation. Once the eigenvalue equation is solved, the approximate price of a derivative can be calculated formulaically. To illustrate our method, we calculate the approximate price of three derivative-assets: a vanilla option on a defaultable stock, a path-dependent option on a non-defaultable stock, and a bond in a short-rate model.
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Cited in
(8)- The averaging principle for non-autonomous slow-fast stochastic differential equations and an application to a local stochastic volatility model
- Positive eigenfunctions of Markovian pricing operators: Hansen-Scheinkman factorization, Ross recovery, and long-term pricing
- Pricing Options on Scalar Diffusions: An Eigenfunction Expansion Approach
- Asymptotics for d -Dimensional Lévy-Type Processes
- First-order asymptotics of path-dependent derivatives in multiscale stochastic volatility environment
- Application of the spectral theory and perturbation theory to the study of Ornstein-Uhlenbeck processes
- Short Communication: Pricing Path-Dependent Derivatives under Multiscale Stochastic Volatility Models: A Malliavin Representation
- The exact smile of certain local volatility models
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