Kristensen, Dennis and Mele, Antonio (2011) Adding and subtracting Black-Scholes: a new approach to approximating derivative prices in continuous-time models. Journal of financial economics, 102 (2). pp. 390-415. ISSN 0304-405X
We develop a new approach to approximating asset prices in the context of continuous-time models. For any pricing model that lacks a closed-form solution, we provide a closed-form approximate solution, which relies on the expansion of the intractable model around an "auxiliary" one. We derive an expression for the difference between the true (but unknown) price and the auxiliary one, which we approximate in closed-form, and use to create increasingly improved refinements to the initial mispricing induced by the auxiliary model. The approach is intuitive, simple to implement, and leads to fast and extremely accurate approximations. We illustrate this method in a variety of contexts including option pricing with stochastic volatility, computation of Greeks, and the term structure of interest rates.
|Additional Information:||© 2011 Elsevier B.V|
|Uncontrolled Keywords:||ISI, closed-form approximations, continuous-time models, option pricing theory, stochastic volatility|
|Library of Congress subject classification:||H Social Sciences > HG Finance|
|Sets:||Departments > Finance|
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