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A Put-Call Transformation of the Exchange Option Problem under Stochastic Volatility and Jump Diffusion Dynamics

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  • Len Patrick Dominic M. Garces
  • Gerald H. L. Cheang

Abstract

We price European and American exchange options where the underlying asset prices are modelled using a Merton (1976) jump-diffusion with a common Heston (1993) stochastic volatility process. Pricing is performed under an equivalent martingale measure obtained by setting the second asset yield process as the numeraire asset, as suggested by Bjerskund and Stensland (1993). Such a choice for the numeraire reduces the exchange option pricing problem, a two-dimensional problem, to pricing a call option written on the ratio of the yield processes of the two assets, a one-dimensional problem. The joint transition density function of the asset yield ratio process and the instantaneous variance process is then determined from the corresponding Kolmogorov backward equation via integral transforms. We then determine integral representations for the European exchange option price and the early exercise premium and state a linked system of integral equations that characterizes the American exchange option price and the associated early exercise boundary. Properties of the early exercise boundary near maturity are also discussed.

Suggested Citation

  • Len Patrick Dominic M. Garces & Gerald H. L. Cheang, 2020. "A Put-Call Transformation of the Exchange Option Problem under Stochastic Volatility and Jump Diffusion Dynamics," Papers 2002.10194, arXiv.org.
    • Handle: RePEc:arx:papers:2002.10194
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    References listed on IDEAS

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    Cited by:

    1. Len Patrick Dominic M. Garces & Gerald H. L. Cheang, 2021. "A Numerical Approach to Pricing Exchange Options under Stochastic Volatility and Jump-Diffusion Dynamics," Papers 2106.07362, arXiv.org.

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