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Pricing options on a mean-reverting asset by the analytical operator splitting method

Author

Listed:
  • C. F. Lo

    (Institute of Theoretical Physics and Department of Physics, The Chinese University of Hong Kong, Shatin, New Territories, Hong Kong)

  • Y. W. He

    (Institute of Theoretical Physics and Department of Physics, The Chinese University of Hong Kong, Shatin, New Territories, Hong Kong)

Abstract

In this paper, we propose an operator splitting method to valuate options on the inhomogeneous geometric Brownian motion. By exploiting the approximate dynamical symmetry of the pricing equation, we derive a simple closed-form approximate price formula for a European call option which resembles closely the Black–Scholes price formula for a European vanilla call option. Numerical tests show that the proposed method is able to provide very accurate estimates and tight bounds of the exact option prices. The method is very efficient and robust as well.

Suggested Citation

  • C. F. Lo & Y. W. He, 2022. "Pricing options on a mean-reverting asset by the analytical operator splitting method," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 9(02), pages 1-16, June.
    • Handle: RePEc:wsi:ijfexx:v:09:y:2022:i:02:n:s242478632150002x
    DOI: 10.1142/S242478632150002X
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