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Option Pricing with Threshold Diffusion Processes

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  • Fei Su
  • Kung-Sik Chan

Abstract

The threshold diffusion (TD) model assumes a piecewise linear drift term and piecewise smooth diffusion term, which can capture many nonlinear features and volatility clustering often observed in financial time series data. We solve the problem of option pricing with a TD asset pricing process by deriving the minimum entropy martingale measure, which is the risk-neutral measure closest to the underlying TD probability measure in terms of Kullback-Leibler divergence, given the historical regime-switching pattern. The proposed valuation model is illustrated with a numerical example.

Suggested Citation

  • Fei Su & Kung-Sik Chan, 2016. "Option Pricing with Threshold Diffusion Processes," North American Actuarial Journal, Taylor & Francis Journals, vol. 20(2), pages 133-141, April.
    • Handle: RePEc:taf:uaajxx:v:20:y:2016:i:2:p:133-141
    DOI: 10.1080/10920277.2015.1106953
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    Cited by:

    1. Jordan, Matthias & Millinger, Markus & Thrän, Daniela, 2020. "Robust bioenergy technologies for the German heat transition: A novel approach combining optimization modeling with Sobol’ sensitivity analysis," Applied Energy, Elsevier, vol. 262(C).
    2. Antoine Lejay & Paolo Pigato, 2017. "A threshold model for local volatility: evidence of leverage and mean reversion effects on historical data," Working Papers hal-01669082, HAL.
    3. Yang Shen & Tak Kuen Siu, 2018. "A Risk-Based Approach for Asset Allocation with A Defaultable Share," Risks, MDPI, vol. 6(1), pages 1-27, February.
    4. Antoine Lejay & Paolo Pigato, 2019. "A Threshold Model For Local Volatility: Evidence Of Leverage And Mean Reversion Effects On Historical Data," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 22(04), pages 1-24, June.
    5. Siu, Tak Kuen, 2016. "A self-exciting threshold jump–diffusion model for option valuation," Insurance: Mathematics and Economics, Elsevier, vol. 69(C), pages 168-193.

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