Pricing Derivatives on Multiscale Diffusions: an Eigenfunction Expansion Approach
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.
Keywords
Cite
@article{arxiv.1109.0738,
title = {Pricing Derivatives on Multiscale Diffusions: an Eigenfunction Expansion Approach},
author = {Matthew Lorig},
journal= {arXiv preprint arXiv:1109.0738},
year = {2012}
}