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Exchange Options

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  • Jamshidian, Farshid

Abstract

The contract is described and market examples given. Essential theoretical developments are introduced and cited chronologically. The principles and techniques of hedging and unique pricing are illustrated for the two simplest nontrivial examples: the classical Black-Scholes/Merton/Margrabe exchange option model brought somewhat up-to-date from its form three decades ago, and a lesser exponential Poisson analogue to illustrate jumps. Beyond these, a simplified Markovian SDE/PDE line is sketched in an arbitrage-free semimartingale setting. Focus is maintained on construction of a hedge using Ito's formula and on unique pricing, now for general homogenous payoff functions. Clarity is primed as the multivariate log-Gaussian and exponential Poisson cases are worked out. Numeraire invariance is emphasized as the primary means to reduce dimensionality by one to the projective space where the SDE dynamics are specified and the PDEs solved (or expectations explicitly calculated). Predictable representation of a homogenous payoff with deltas (hedge ratios) as partial derivatives or partial differences of the option price function is highlighted. Equivalent martingale measures are utilized to show unique pricing with bounded deltas (and in the nondegenerate case unique hedging) and to exhibit the PDE or closed-form solutions as numeraire-deflated conditional expectations in the usual way. Homogeneity, change of numeraire, and extension to dividends are discussed.

Suggested Citation

  • Jamshidian, Farshid, 2007. "Exchange Options," MPRA Paper 4471, University Library of Munich, Germany, revised 14 Aug 2007.
  • Handle: RePEc:pra:mprapa:4471
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    References listed on IDEAS

    as
    1. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters,in: Theory Of Valuation, chapter 8, pages 229-288 World Scientific Publishing Co. Pte. Ltd..
    2. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
    3. Harrison, J. Michael & Pliska, Stanley R., 1981. "Martingales and stochastic integrals in the theory of continuous trading," Stochastic Processes and their Applications, Elsevier, vol. 11(3), pages 215-260, August.
    4. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    5. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-186, March.
    6. Farshid Jamshidian, 1993. "Option and Futures Evaluation With Deterministic Volatilities," Mathematical Finance, Wiley Blackwell, vol. 3(2), pages 149-159.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Hedging; self-financing trading strategy; numeraire invariance; predictable representation; unique pricing; arbitrage-free; martingale; homogeneous payoff; Markovian; It^o's formula; SDE; PDE; geometric Brownian motion; exponential Poisson process;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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