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A PDE approach to jump-diffusions

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  • Peter Carr
  • Laurent Cousot

Abstract

In this paper, we show that the calibration to an implied volatility surface and the pricing of contingent claims can be as simple in a jump-diffusion framework as in a diffusion framework. Indeed, after defining the jump densities as those of diffusions sampled at independent and exponentially distributed random times, we show that the forward and backward Kolmogorov equations can be transformed into partial differential equations. This enables us to (i) derive Dupire-like equations [Risk Mag., 1994, 7(1), 18-20] for coefficients characterizing these jump-diffusions; (ii) describe sufficient conditions for the processes they induce to be calibrated martingales; and (iii) price path-independent claims using backward partial differential equations. This paper also contains an example of calibration to the S&P 500 market.

Suggested Citation

  • Peter Carr & Laurent Cousot, 2011. "A PDE approach to jump-diffusions," Quantitative Finance, Taylor & Francis Journals, vol. 11(1), pages 33-52.
    • Handle: RePEc:taf:quantf:v:11:y:2011:i:1:p:33-52
    DOI: 10.1080/14697688.2010.531042
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