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Jul 1

Adding and Subtracting Black-Scholes:A New Approach to Approximating Derivative Prices in Continuous-Time Models

Posted by abiao at 09:48 | Paper Review | Comments(0) | Reads(8764)
To be honest, I haven't read this paper yet as my research interest has moved gradually from no-arbitrage to arbitrage valuation, however, this paper Adding and Subtracting Black-Scholes:A New Approach to Approximating Derivative Prices in Continuous-Time Models is very interesting from its abstract and may be appealing to some of you.

Adding and Subtracting Black-Scholes: A New Approach to Approximating Derivative Prices in Continuous-Time Models is written by Dennis Kristensen, Antonio Mele, and is accepted by Journal of Financial Economics.
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 solution, which relies on the approximation of the intractable model through a known, "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, volatility contracts and the term-structure of interest rates.


A working paper is available at http://w4.stern.nyu.edu/volatility/docs/Kristensen.pdf


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