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Pricing Options on Scalar Diffusions: An Eigenfunction Expansion Approach

Author

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  • Dmitry Davydov

    (Equities Quantitative Strategies, UBS Warburg, Stamford, Connecticut 06901)

  • Vadim Linetsky

    (Department of Industrial Engineering and Management Sciences, McCormick School of Engineering and Applied Sciences, Northwestern University, Evanston, Illinios 60208)

Abstract

This paper develops an eigenfunction expansion approach to pricing options on scalar diffusion processes. All contingent claims are unbundled into portfolios of primitive securities called eigensecurities . Eigensecurities are eigenvectors (eigenfunctions) of the pricing operator (present value operator). All computational work is at the stage of finding eigenvalues and eigenfunctions of the pricing operator. The pricing is then immediate by the linearity of the pricing operator and the eigenvector property of eigensecurities. To illustrate the computational power of the method, we develop two applications:pricing vanilla, single- and double-barrier options under the constant elasticity of variance (CEV) process and interest rate knock-out options in the Cox-Ingersoll-Ross (CIR) term-structure model.

Suggested Citation

  • Dmitry Davydov & Vadim Linetsky, 2003. "Pricing Options on Scalar Diffusions: An Eigenfunction Expansion Approach," Operations Research, INFORMS, vol. 51(2), pages 185-209, April.
    • Handle: RePEc:inm:oropre:v:51:y:2003:i:2:p:185-209
    DOI: 10.1287/opre.51.2.185.12782
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    References listed on IDEAS

    as
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