The Pricing of Dual-Expiry Exotics with Mean Reversion and Jumps

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DOI: 10.4236/jmf.2019.91003    865 Downloads   1,865 Views  Citations

ABSTRACT

This paper develops a new class of models for pricing dual-expiry options that are characterized by two expiry dates. The underlying asset price is modeled by a time changed exponential Ornstein Uhlenbeck (OU) process, where the time change process is a Lévy subordinator. The new models can capture both mean reversion and jumps often observed in various types of underlying assets of exotics. The pricing method exploits the observation that dual expiry options have payoffs that can be perfectly replicated by a particular set of first and second order binary options. The novelty of the paper is that we are able to derive the analytical solutions to the prices of these binaries through eigenfunction expansion method. Based on that, we can obtain the formulas for dual-expiry exotics through static replication. We also numerically investigate the sensitivities of prices of chooser, compound and extendable options with respect to the parameters of the models.

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Tong, K. , Hou, D. and Guan, J. (2019) The Pricing of Dual-Expiry Exotics with Mean Reversion and Jumps. Journal of Mathematical Finance, 9, 25-41. doi: 10.4236/jmf.2019.91003.

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