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Adaptive Continuous time Markov Chain Approximation Model to General Jump-Diusions

  • Cerrato, Mario
  • Lo, Chia Chun
  • Skindilias, Konstantinos
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    We propose a non-equidistant Q rate matrix formula and an adaptive numerical algorithm for a continuous time Markov chain to approximate jump-diffusions with affine or non-affine functional specifications. Our approach also accommodates state-dependent jump intensity and jump distribution, a flexibility that is very hard to achieve with other numerical methods. The Kolmogorov-Smirnov test shows that the proposed Markov chain transition density converges to the one given by the likelihood expansion formula as in Ait-Sahalia (2008). We provide numerical examples for European stock option pricing in Black and Scholes (1973), Merton (1976) and Kou (2002).

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    File URL: http://hdl.handle.net/10943/286
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    Paper provided by Scottish Institute for Research in Economics (SIRE) in its series SIRE Discussion Papers with number 2011-53.

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    Date of creation: 2011
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    Handle: RePEc:edn:sirdps:286
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