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A General Computation Scheme for a High-Order Asymptotic Expansion Method

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  • Akihiko Takahashi

    (Faculty of Economics, University of Tokyo)

  • Kohta Takehara

    (Graduate School of Economics, University of Tokyo)

  • Masashi Toda

    (Graduate School of Economics, University of Tokyo)

Abstract

This paper presents a new computational scheme for an asymptotic expansion method of an arbitrary order. The asymptotic expansion method in finance initiated by Kunitomo and Takahashi [9], Yoshida [34] and Takahashi [20], [21] is a widely applicable methodology for an analytic approximation of expectation of a certain functional of diffusion processes. Hence, not only academic researchers but also many practitioners have used the methodology for a variety of financial issues such as pricing or hedging complex derivatives under high-dimensional underlying stochastic environments. In practical applications of the expansion, a crucial step is calculation of conditional expectations for a certain kind of Wiener functionals. [20], [21] and Takahashi and Takehara [23] provided explicit formulas for those conditional expectations necessary for the asymptotic expansion up to the third order. This paper presents the new method for computing an arbitrary-order expansion in a general diffusion-type stochastic environment, which is powerful especially for high-order expansions: We develops a new calculation algorithm for computing coefficients of the expansion through solving a system of ordinary differential equations that is equivalent to computing the conditional expectations directly. To demonstrate its effectiveness, the paper gives numerical examples of the approximation for a ă-SABR model up to the fifth order and a cross-currency Libor market model with a general stochastic volatility model of the spot foreign exchange rate up to the fourth order.

Suggested Citation

  • Akihiko Takahashi & Kohta Takehara & Masashi Toda, 2011. "A General Computation Scheme for a High-Order Asymptotic Expansion Method," CARF F-Series CARF-F-242, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo, revised Jul 2011.
  • Handle: RePEc:cfi:fseres:cf242
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    File URL: http://www.carf.e.u-tokyo.ac.jp/pdf/workingpaper/fseries/252.pdf
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    1. Yoshifumi Muroi, 2005. "Pricing contingent claims with credit risk: Asymptotic expansion approach," Finance and Stochastics, Springer, vol. 9(3), pages 415-427, July.
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