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Testing the Closed-Form Spread Option Pricing Formula Based on Gauss-Hermite Quadrature for a Jump-Diffusion Model

Author

Listed:
  • Xenos Chang-Shuo Lin

    (Aletheia University)

  • Daniel Wei-Chung Miao

    (National Taiwan University of Science and Technology)

  • Emma En-Tze Chang

    (Yuanta Commercial Bank)

Abstract

In this paper we develop a closed-form spread option pricing formula based on Gauss-Hermite quadrature (GHQ) and show that the proposed method is a competitive method for the Black-Scholes model and is best-suited for the jump-diffusion model. The GHQ method turns the integral of spread option pricing formula into a summation of call option pricing formulas with adjusted parameters, and therefore the final formula remains in closed-form which ensures its computational advantage. Under the basic Black-Scholes model, the proposed GHQ formula provides equally nice accuracy compared to the best-performing LDZ formula in the literature. But for the extended jump-diffusion model, the LDZ formula sees a significant loss of accuracy due to the multi-layered summation, whereas the GHQ formula is still able to achieve very high accuracy at only slightly increased computing costs. Various closed-form formulas are tested in our numerical analysis which demonstrates that the proposed GHQ formula is the most recommended for pricing spread options under the jump-diffusion model.

Suggested Citation

  • Xenos Chang-Shuo Lin & Daniel Wei-Chung Miao & Emma En-Tze Chang, 2024. "Testing the Closed-Form Spread Option Pricing Formula Based on Gauss-Hermite Quadrature for a Jump-Diffusion Model," Computational Economics, Springer;Society for Computational Economics, vol. 64(5), pages 2879-2908, November.
    • Handle: RePEc:kap:compec:v:64:y:2024:i:5:d:10.1007_s10614-023-10468-2
    DOI: 10.1007/s10614-023-10468-2
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    References listed on IDEAS

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