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Pricing Path-Dependent Options On State Dependent Volatility Models With A Bessel Bridge

Author

Listed:
  • GIUSEPPE CAMPOLIETI

    (Department of Mathematics, Wilfrid Laurier University, 75 University Avenue West, Waterloo, Ontario N2L 3C5, Canada)

  • ROMAN MAKAROV

    (Department of Mathematics, Wilfrid Laurier University, 75 University Avenue West, Waterloo, Ontario N2L 3C5, Canada)

Abstract

This paper develops bridge sampling path integral algorithms for pricing path-dependent options under a new class of nonlinear state dependent volatility models. Path-dependent option pricing is considered within a new (dual) Bessel family of semimartingale diffusion models, as well as the constant elasticity of variance (CEV) diffusion model, arising as a particular case of these models. The transition p.d.f.s or pricing kernels are mapped onto an underlying simpler squared Bessel process and are expressed analytically in terms of modified Bessel functions. We establish precise links between pricing kernels of such models and the randomized gamma distributions, and thereby demonstrate how a squared Bessel bridge process can be used for exact sampling of the Bessel family of paths. A Bessel bridge algorithm is presented which is based on explicit conditional distributions for the Bessel family of volatility models and is similar in spirit to the Brownian bridge algorithm. A special rearrangement and splitting of the path integral variables allows us to combine the Bessel bridge sampling algorithm with either adaptive Monte Carlo algorithms, or quasi-Monte Carlo techniques for significant numerical efficiency improvement. The algorithms are illustrated by pricing Asian-style and lookback options under the Bessel family of volatility models as well as the CEV diffusion model.

Suggested Citation

  • Giuseppe Campolieti & Roman Makarov, 2007. "Pricing Path-Dependent Options On State Dependent Volatility Models With A Bessel Bridge," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 10(01), pages 51-88.
    • Handle: RePEc:wsi:ijtafx:v:10:y:2007:i:01:n:s0219024907004081
    DOI: 10.1142/S0219024907004081
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    References listed on IDEAS

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    1. Albanese, Claudio & Campolieti, Giuseppe, 2005. "Advanced Derivatives Pricing and Risk Management," Elsevier Monographs, Elsevier, edition 1, number 9780120476824.
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    Cited by:

    1. Makarov Roman N. & Glew Devin, 2010. "Exact simulation of Bessel diffusions," Monte Carlo Methods and Applications, De Gruyter, vol. 16(3-4), pages 283-306, January.
    2. Giuseppe Campolieti & Roman N. Makarov & Andrey Vasiliev, 2011. "Bridge Copula Model for Option Pricing," Papers 1110.4669, arXiv.org.
    3. Ian Iscoe & Asif Lakhany, 2011. "Adaptive Simulation of the Heston Model," Papers 1111.6067, arXiv.org.

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