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Smart expansion and fast calibration for jump diffusions

Author

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  • E. Benhamou
  • E. Gobet
  • M. Miri

Abstract

Using Malliavin calculus techniques, we derive an analytical formula for the price of European options, for any model including local volatility and Poisson jump process. We show that the accuracy of the formula depends on the smoothness of the payoff function. Our approach relies on an asymptotic expansion related to small diffusion and small jump frequency/size. Our formula has excellent accuracy (the error on implied Black-Scholes volatilities for call option is smaller than 2 bp for various strikes and maturities). Additionally, model calibration becomes very rapid.
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Suggested Citation

  • E. Benhamou & E. Gobet & M. Miri, 2009. "Smart expansion and fast calibration for jump diffusions," Finance and Stochastics, Springer, vol. 13(4), pages 563-589, September.
    • Handle: RePEc:spr:finsto:v:13:y:2009:i:4:p:563-589
    DOI: 10.1007/s00780-009-0102-3
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    References listed on IDEAS

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    1. Patrick Hagan & Diana Woodward, 1999. "Equivalent Black volatilities," Applied Mathematical Finance, Taylor & Francis Journals, vol. 6(3), pages 147-157.
    2. Bouchard, Bruno & Elie, Romuald, 2008. "Discrete-time approximation of decoupled Forward-Backward SDE with jumps," Stochastic Processes and their Applications, Elsevier, vol. 118(1), pages 53-75, January.
    3. Eric Fournié & Jean-Michel Lasry & Pierre-Louis Lions & Jérôme Lebuchoux & Nizar Touzi, 1999. "Applications of Malliavin calculus to Monte Carlo methods in finance," Finance and Stochastics, Springer, vol. 3(4), pages 391-412.
    4. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
    5. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley.
    6. Emmanuel Gobet, 2004. "Revisiting the Greeks for European and American Options," World Scientific Book Chapters, in: Jiro Akahori & Shigeyoshi Ogawa & Shinzo Watanabe (ed.), Stochastic Processes And Applications To Mathematical Finance, chapter 3, pages 53-71, World Scientific Publishing Co. Pte. Ltd..
    7. Alan L. Lewis, 2000. "Option Valuation under Stochastic Volatility," Option Valuation under Stochastic Volatility, Finance Press, number ovsv.
    8. Rama Cont & Ekaterina Voltchkova, 2005. "A Finite Difference Scheme for Option Pricing in Jump Diffusion and Exponential Lévy Models," Post-Print halshs-00445645, HAL.
    9. Rubinstein, Mark, 1994. "Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
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    More about this item

    Keywords

    Asymptotic expansion; Malliavin calculus; Volatility skew and smile; Small diffusion process; Small jump frequency/size; 60J75; 60HXX; G13;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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