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Sequential real rainbow options

Author

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  • Jörg Dockendorf
  • Dean A. Paxson

Abstract

We develop two models to value European sequential rainbow options. The first model is a sequential option on the better of two stochastic assets, where these assets follow correlated geometric Brownian motion processes. The second model is a sequential option on the mean-reverting spread between two assets, which is applicable if the assets are co-integrated. We provide numerical solutions in the form of finite difference frameworks and compare these with Monte Carlo simulations. For the sequential option on a mean-reverting spread, we also provide a closed-form solution. Sensitivity analysis provides the interesting results that in particular circumstances, the sequential rainbow option value is negatively correlated with the volatility of one of the two assets, and that the sequential option on the spread does not necessarily increase in value with a longer time to maturity. With given maturity dates, it is preferable to have less time until expiry of the sequential option if the current spread level is way above the long-run mean.

Suggested Citation

  • Jörg Dockendorf & Dean A. Paxson, 2015. "Sequential real rainbow options," The European Journal of Finance, Taylor & Francis Journals, vol. 21(10-11), pages 867-892, August.
    • Handle: RePEc:taf:eurjfi:v:21:y:2015:i:10-11:p:867-892
    DOI: 10.1080/1351847X.2012.719531
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    Cited by:

    1. Malek Ben-Abdellatif & Hatem Ben-Ameur & Rim Chérif & Bruno Rémillard, 2024. "A two-factor structural model for valuing corporate securities," Review of Derivatives Research, Springer, vol. 27(2), pages 203-225, July.
    2. Wang, Lu & Zhang, Rong & Yang, Lin & Su, Yang & Ma, Feng, 2018. "Pricing geometric Asian rainbow options under fractional Brownian motion," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 494(C), pages 8-16.

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