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McKean's Methods Applied to American Call Options on Jump-Diffusion Processes

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Abstract

In this paper we derive the implicit integral equation for the price of an American call option in the case where the underlying asset follows a jump-diffusion process. We extend McKean's incomplete Fourier transform approach to solve the free boundary problem under Merton's framework, with the distribution for the jump size remaining unspecified. We show how our results are consistent with those of Gukhal (2001), who derived the same integral equation using the Geske-Johnson discretisation approach. The paper also derives some results concerning the limit for the free boundary at expiry, and presents an iterative numerical algorithm for solving the linked integral equation system for the American call's price and early exercise boundary. This scheme is applied to Merton's jump-diffusion model, where the jumps are log-normally distributed.

Suggested Citation

  • Carl Chiarella & Andrew Ziogas, 2004. "McKean's Methods Applied to American Call Options on Jump-Diffusion Processes," Research Paper Series 117, Quantitative Finance Research Centre, University of Technology, Sydney.
  • Handle: RePEc:uts:rpaper:117
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    1. Chiarella, Carl & Ziogas, Andrew, 2005. "Evaluation of American strangles," Journal of Economic Dynamics and Control, Elsevier, vol. 29(1-2), pages 31-62, January.
    2. Mulinacci, Sabrina, 1996. "An approximation of American option prices in a jump-diffusion model," Stochastic Processes and their Applications, Elsevier, vol. 62(1), pages 1-17, March.
    3. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
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    7. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
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    9. Peter Carr & Robert Jarrow & Ravi Myneni, 2008. "Alternative Characterizations Of American Put Options," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 5, pages 85-103, World Scientific Publishing Co. Pte. Ltd..
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    11. Bates, David S, 1996. "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in Deutsche Mark Options," The Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 69-107.
    12. Philippe Jorion, 1988. "On Jump Processes in the Foreign Exchange and Stock Markets," The Review of Financial Studies, Society for Financial Studies, vol. 1(4), pages 427-445.
    13. Geske, Robert & Johnson, Herb E, 1984. "The American Put Option Valued Analytically," Journal of Finance, American Finance Association, vol. 39(5), pages 1511-1524, December.
    14. S. D. Jacka, 1991. "Optimal Stopping and the American Put," Mathematical Finance, Wiley Blackwell, vol. 1(2), pages 1-14, April.
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    Cited by:

    1. Min Dai & Yue Kuen Kwok, 2006. "Characterization Of Optimal Stopping Regions Of American Asian And Lookback Options," Mathematical Finance, Wiley Blackwell, vol. 16(1), pages 63-82, January.
    2. Len Patrick Dominic M. Garces & Gerald H. L. Cheang, 2021. "A numerical approach to pricing exchange options under stochastic volatility and jump-diffusion dynamics," Quantitative Finance, Taylor & Francis Journals, vol. 21(12), pages 2025-2054, December.
    3. Chiarella, Carl & Ziogas, Andrew, 2005. "Evaluation of American strangles," Journal of Economic Dynamics and Control, Elsevier, vol. 29(1-2), pages 31-62, January.
    4. Andrew Ziogas & Carl Chiarella, 2004. "Pricing American Options on Jump-Diffusion Processes using Fourier-Hermite Series Expansions," Computing in Economics and Finance 2004 177, Society for Computational Economics.

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    More about this item

    Keywords

    american options; jump-diffusion; volterra integral equation; free-boundary problem;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory

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