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

  • Sven Rady


    (Graduate School of Business, Stanford University, Stanford, CA 94305-5015, USA)

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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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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