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Pricing of a Binary Option Under a Mixed Exponential Jump Diffusion Model

Author

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  • Yichen Lu

    (School of Applied Mathematics, Nanjing University of Finance and Economics, Nanjing 210023, China)

  • Ruili Song

    (School of Applied Mathematics, Nanjing University of Finance and Economics, Nanjing 210023, China)

Abstract

This paper focuses on the pricing problem of binary options under stochastic interest rates, stochastic volatility, and a mixed exponential jump diffusion model. Considering the negative interest rates in the market in recent years, this paper assumes that the stochastic interest rate follows the Hull–White (HW) model. In addition, we assume that the stochastic volatility follows the Heston volatility model, and the price of the underlying asset follows the jump diffusion model in which the jumps follow the mixed exponential jump model. Considering these factors comprehensively, the mixed exponential jump diffusion of the Heston–HW (abbreviated as MEJ-Heston–HW) model is established. Using the idea of measure transformation, the pricing formula of binary call options is derived by the martingale method, eigenfunction, and Fourier transform. Finally, the effects of the volatility term and the parameters of the mixed-exponential jump diffusion model on the option price in the O-U process are analyzed. In the numerical simulation, compared with the double exponential jump Heston–HW (abbreviated as DEJ-Heston–HW) model and the Heston–HW model, the mixed exponential jump model is an extension of the double exponential jump model, which can approximate any distribution in the sense of weak convergence, including arbitrary discrete distributions, normal distributions, and various thick-tailed distributions. Therefore, the MEJ-Heston–HW model adopted in this paper can better describe the price of the underlying asset.

Suggested Citation

  • Yichen Lu & Ruili Song, 2024. "Pricing of a Binary Option Under a Mixed Exponential Jump Diffusion Model," Mathematics, MDPI, vol. 12(20), pages 1-14, October.
    • Handle: RePEc:gam:jmathe:v:12:y:2024:i:20:p:3233-:d:1499426
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    References listed on IDEAS

    as
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