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Decomposition formula for jump diffusion models

Authors :
Merino, Raul
Pospíšil, Jan
Sobotka, Tomáš
Vives, Josep
Source :
Int. J. Theor. Appl. Finance 21(8), 1850052, 2018
Publication Year :
2019

Abstract

In this paper we derive a generic decomposition of the option pricing formula for models with finite activity jumps in the underlying asset price process (SVJ models). This is an extension of the well-known result by Alos (2012) for Heston (1993) SV model. Moreover, explicit approximation formulas for option prices are introduced for a popular class of SVJ models - models utilizing a variance process postulated by Heston (1993). In particular, we inspect in detail the approximation formula for the Bates (1996) model with log-normal jump sizes and we provide a numerical comparison with the industry standard - Fourier transform pricing methodology. For this model, we also reformulate the approximation formula in terms of implied volatilities. The main advantages of the introduced pricing approximations are twofold. Firstly, we are able to significantly improve computation efficiency (while preserving reasonable approximation errors) and secondly, the formula can provide an intuition on the volatility smile behaviour under a specific SVJ model.

Details

Database :
arXiv
Journal :
Int. J. Theor. Appl. Finance 21(8), 1850052, 2018
Publication Type :
Report
Accession number :
edsarx.1906.06930
Document Type :
Working Paper
Full Text :
https://doi.org/10.1142/S0219024918500528