Pricing options on scalar diffusions: An eigenfunction expansion approach

Dmitry Davydov*, Vadim Linetsky

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

98 Scopus citations

Abstract

This paper develops an eigenfunction expansion approach to pricing options on scalar diffusion processes. All contingent claims are unbundled into portfolios of primitive securities called eigensecurities. Eigensecurities are eigenvectors (eigenfunctions) of the pricing operator (present value operator). All computational work is at the stage of finding eigenvalues and eigenfunctions of the pricing operator. The pricing is then immediate by the linearity of the pricing operator and the eigenvector property of eigensecurities. To illustrate the computational power of the method, we develop two applications: pricing vanilla, single- and double-barrier options under the constant elasticity of variance (CEV) process and interest rate knock-out options in the Cox-Ingersoll-Ross (CIR) term-structure model.

Original languageEnglish (US)
Pages (from-to)185-209
Number of pages25
JournalOperations Research
Volume51
Issue number2
DOIs
StatePublished - Mar 2003

Keywords

  • Finance, asset pricing: option pricing, CEV model, CIR model
  • Finance, securities: barrier options
  • Probability, diffusion: spectral theory, barrier crossing, generalized Bessel process

ASJC Scopus subject areas

  • Computer Science Applications
  • Management Science and Operations Research

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