DECOMPOSITION FORMULA FOR JUMP DIFFUSION MODELS
Abstract
In this paper, we derive a generic decomposition of the option pricing formula for models with finite activity jumps in the underlying asset price process (SVJ models). This is an extension of the well-known result by Alòs [(2012) A decomposition formula for option prices in the Heston model and applications to option pricing approximation, Finance and Stochastics16 (3), 403–422, doi:https://doi.org/10.1007/s00780-012-0177-0] for Heston [(1993) A closed-form solution for options with stochastic volatility with applications to bond and currency options, The Review of Financial Studies6 (2), 327–343, doi:https://doi.org/10.1093/rfs/6.2.327] SV model. Moreover, explicit approximation formulas for option prices are introduced for a popular class of SVJ models — models utilizing a variance process postulated by Heston [(1993) A closed-form solution for options with stochastic volatility with applications to bond and currency options, The Review of Financial Studies6 (2), 327–343, doi:https://doi.org/10.1093/rfs/6.2.327]. In particular, we inspect in detail the approximation formula for the Bates [(1996), Jumps and stochastic volatility: Exchange rate processes implicit in Deutsche mark options, The Review of Financial Studies9 (1), 69–107, doi:https://doi.org/10.1093/rfs/9.1.69] model with log-normal jump sizes and we provide a numerical comparison with the industry standard — Fourier transform pricing methodology. For this model, we also reformulate the approximation formula in terms of implied volatilities. The main advantages of the introduced pricing approximations are twofold. Firstly, we are able to significantly improve computation efficiency (while preserving reasonable approximation errors) and secondly, the formula can provide an intuition on the volatility smile behavior under a specific SVJ model.
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