Representation of exchange option prices under stochastic volatility jump-diffusion dynamics

• Main Authors: Cheang, Gerald H L, Garces, Len Patrick Dominic M
• Format: text
• Published: Archīum Ateneo 2019
• Subjects: American options; Exchange options; Fourier transform methods; Jump diffusion processes; Stochastic volatility; Mathematics
• Online Access: https://archium.ateneo.edu/mathematics-faculty-pubs/73; https://www.tandfonline.com/doi/full/10.1080/14697688.2019.1655785?casa_token=OEuW633C56IAAAAA%3A8I2H9k7IWAuKP75wbIW2euTWKM8WtIllnokX7KZPVHaK0-uNOWHT4RaNjqaOon_wtVK2kOHPy3f8rA#
• Institution: Ateneo De Manila University

In this article, we provide representations of European and American exchange option prices under stochastic volatility jump-diffusion (SVJD) dynamics following models by Merton [Option pricing when underlying stock returns are discontinuous. J. Financ. Econ., 1976, 3(1-2), 125–144], Heston [A closed-form solution for options with stochastic volatility with applications to bond and currency options. Rev. Financ. Stud., 1993, 6(2), 327–343], and Bates [Jumps and stochastic volatility: Exchange rate processes implicit in Deutsche Mark options. Rev. Financ. Stud., 1996, 9(1), 69–107]. A Radon–Nikodým derivative process is also introduced to facilitate the shift from the objective market measure to other equivalent probability measures, including the equivalent martingale measure. Under the equivalent martingale measure, we derive the integro-partial differential equation that characterizes the exchange option prices. We also derive representations of the European exchange option price using the change-of-numéraire technique proposed by Geman et al. [Changes of numéraire, changes of probability measure and option pricing. J. Appl. Probab., 1995, 32(2), 443–458] and the Fourier inversion formula derived by Caldana and Fusai [A general closed-form spread option pricing formula. J. Bank. Finance, 2013, 37, 4893–4906], and show that these two representations are comparable. Lastly, we show that the American exchange option price can be decomposed into the price of the European exchange option and an early exercise premium.