Symmetries in Jump-Diffusion Models with Applications in Option Pricing and Credit Risk
It is a well known fact that local scale invariance plays a fundamental role in the theory of derivative pricing. Specific applications of this principle have been used quite often under the name of `change of numeraire', but in recent work it was shown that when invoked as a fundamental first principle, it provides a powerful alternative method for the derivation of prices and hedges of derivative securities, when prices of the underlying tradables are driven by Wiener processes. In this article we extend this work to the pricing problem in markets driven not only by Wiener processes but also by Poisson processes, i.e. jump-diffusion models. It is shown that in this case too, the focus on symmetry aspects of the problem leads to important simplifications of, and a deeper insight into the problem. Among the applications of the theory we consider the pricing of stock options in the presence of jumps, and Levy-processes. Next we show how the same theory, by restricting the number of jumps, can be used to model credit risk, leading to a `market model' of credit risk. Both the traditional Duffie- Singleton and Jarrow-Turnbull models can be described within this framework, but also more general models, which incorporate default correlation in a consistent way. As an application of this theory we look at the pricing of a credit default swap (CDS) and a first-to- default basket option.
|Date of creation:||04 Mar 2002|
|Date of revision:|
|Note:||Type of Document - PDF; prepared on Linux; to print on Postscript; pages: 34 ; figures: none|
|Contact details of provider:|| Web page: http://econwpa.repec.org|
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Jiri Hoogland & Dimitri Neumann, 2001. "Tradable Schemes," Finance 0105003, EconWPA.
- Robert Jarrow & Dilip Madan, 1995. "Option Pricing Using The Term Structure Of Interest Rates To Hedge Systematic Discontinuities In Asset Returns," Mathematical Finance, Wiley Blackwell, vol. 5(4), pages 311-336.
- Merton, Robert C., 1976.
"Option pricing when underlying stock returns are discontinuous,"
Journal of Financial Economics,
Elsevier, vol. 3(1-2), pages 125-144.
- Merton, Robert C., 1975. "Option pricing when underlying stock returns are discontinuous," Working papers 787-75., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Jarrow, Robert A & Turnbull, Stuart M, 1995. " Pricing Derivatives on Financial Securities Subject to Credit Risk," Journal of Finance, American Finance Association, vol. 50(1), pages 53-85, March.
When requesting a correction, please mention this item's handle: RePEc:wpa:wuwpfi:0203001. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (EconWPA)
If references are entirely missing, you can add them using this form.