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Symmetries in Jump-Diffusion Models with Applications in Option Pricing and Credit Risk

Author

Listed:
  • Jiri Hoogland

    (CWI, Amsterdam)

  • Dimitri Neumann

    (CWI, Amsterdam)

  • Michel Vellekoop

    (University of Twente)

Abstract

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.

Suggested Citation

  • Jiri Hoogland & Dimitri Neumann & Michel Vellekoop, 2002. "Symmetries in Jump-Diffusion Models with Applications in Option Pricing and Credit Risk," Finance 0203001, EconWPA.
  • Handle: RePEc:wpa:wuwpfi:0203001
    Note: Type of Document - PDF; prepared on Linux; to print on Postscript; pages: 34 ; figures: none
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    File URL: http://econwpa.repec.org/eps/fin/papers/0203/0203001.pdf
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    References listed on IDEAS

    as
    1. 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.
    2. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409 World Scientific Publishing Co. Pte. Ltd..
    3. Jiri Hoogland & Dimitri Neumann, 2001. "Tradable Schemes," Finance 0105003, EconWPA.
    4. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    option pricing; jump diffusion; local scale invariance; homogeneity; partial differential difference equations;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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