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Option pricing in the presence of natural boundaries and a quadratic diffusion term (*)

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Author Info
Sven Rady () (Graduate School of Business, Stanford University, Stanford, CA 94305-5015, USA)

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Abstract

This paper uses a probabilistic change-of-numeraire technique to compute closed-form prices of European options to exchange one asset against another when the relative price of the underlying assets follows a diffusion process with natural boundaries and a quadratic diffusion coefficient. The paper shows in particular how to interpret the option price formula in terms of exercise probabilities which are calculated under the martingale measures associated with two specific numeraire portfolios. An application to the pricing of bond options and certain interest rate derivatives illustrates the main results.

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Publisher Info
Article provided by Springer in its journal Finance and Stochastics.

Volume (Year): 1 (1997)
Issue (Month): 4 ()
Pages: 331-344
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Handle: RePEc:spr:finsto:v:1:y:1997:i:4:p:331-344

Note: received: January 1996; final version received: December 1996
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Web page: http://www.springerlink.com/content/101164/

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Related research
Keywords: Option pricing; bond options; change-of-numeraire technique; diffusion process; quadratic diffusion terms;

Find related papers by JEL classification:
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Christian Zühlsdorff, 2002. "The Pricing of Derivatives on Assets with Quadratic Volatility," Bonn Econ Discussion Papers bgse5_2002, University of Bonn, Germany. [Downloadable!]
  2. Christian Zuhlsdorff, 2001. "The pricing of derivatives on assets with quadratic volatility," Applied Mathematical Finance, Taylor and Francis Journals, vol. 8(4), pages 235-262, December. [Downloadable!] (restricted)
  3. Erik Schlögl, 2001. "Arbitrage-Free Interpolation in Models of Market Observable Interest Rates," Research Paper Series 71, Quantitative Finance Research Centre, University of Technology, Sydney. [Downloadable!]
  4. Christian Zuehlsdorff, 1999. "The Pricing of Derivatives on Assets with Quadratic Volatility," Discussion Paper Serie B 451, University of Bonn, Germany. [Downloadable!]
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