Pricing derivatives on multiscale diffusions: an eigenfunction expansion approach

DOI10.1111/MAFI.12007zbMATH Open1291.91206arXiv1109.0738OpenAlexW3125093288MaRDI QIDQ5416705FDOQ5416705

Authors: Matthew Lorig 

Publication date: 14 May 2014

Published in: Mathematical Finance (Search for Journal in Brave)

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.

Full work available at URL: https://arxiv.org/abs/1109.0738

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zbMATH Keywords

perturbation theorydefaulteigenfunctionlocal volatilityspectral theorystochastic volatilityderivative pricing

Mathematics Subject Classification ID

Derivative securities (option pricing, hedging, etc.) (91G20) Inference from stochastic processes and spectral analysis (62M15) Perturbation theory of linear operators (47A55) Financial applications of other theories (91G80)

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Cited In (8)

• Pricing Options on Scalar Diffusions: An Eigenfunction Expansion Approach
• The averaging principle for non-autonomous slow-fast stochastic differential equations and an application to a local stochastic volatility model
• Asymptotics for $$d$$ -Dimensional Lévy-Type Processes
• Short Communication: Pricing Path-Dependent Derivatives under Multiscale Stochastic Volatility Models: A Malliavin Representation
• Positive eigenfunctions of Markovian pricing operators: Hansen-Scheinkman factorization, Ross recovery, and long-term pricing
• 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
• The exact smile of certain local volatility models

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