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

  • Dennis Kristensen

    ()

    (Columbia University and CREATES)

  • Antonio Mele

    ()

    (London School of Economics)

This paper develops a new systematic approach to implement approximate solutions to asset pricing models within multi-factor diffusion environments. For any model lacking a closed-form solution, we provide a solution obtained by expanding the analytically intractable model around a known auxiliary pricing function. We derive power series expansions, which provide increasingly improved refinements to the initial mispricing arising from the use of the auxiliary model. In practice, the expansions can be truncated to include only a few terms to generate extremely accurate approximations. We illustrate our methodology in a variety of contexts, including option pricing with stochastic volatility, volatility contracts and the term-structure of interest rates.

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Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2009-14.

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Length: 33
Date of creation: 05 Apr 2009
Date of revision:
Handle: RePEc:aah:create:2009-14
Contact details of provider: Web page: http://www.econ.au.dk/afn/

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