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Generalized Transform Analysis of Affine Processes and Applications in Finance

Hui Chen

Massachusetts Institute of Technology; National Bureau of Economic Research (NBER)

Scott Joslin

University of Southern California

September 20, 2011

Non-linearity is an important consideration in many problems of finance and economics, such as pricing securities and solving equilibrium models. This paper provides analytical treatment of a general class of nonlinear transforms for processes with tractable conditional characteristic functions, which extends existing results on characteristic function based transforms to a substantially wider class of nonlinear functions while maintaining low dimensionality by avoiding the need to compute the density function. We illustrate the applications of the generalized transform in pricing defaultable bonds with stochastic recovery. We also use the method to analytically solve a class of general equilibrium models with multiple goods and apply this model to study the effects of time-varying labor income risk on the equity premium.

Number of Pages in PDF File: 43

Keywords: option pricing, recovery risk, stochastic discount factor, characteristic function, Fourier transform

JEL Classification: G10, G12, G13, C5

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Date posted: February 17, 2009 ; Last revised: September 22, 2011

Suggested Citation

Chen, Hui and Joslin, Scott, Generalized Transform Analysis of Affine Processes and Applications in Finance (September 20, 2011). Available at SSRN: http://ssrn.com/abstract=1344915 or http://dx.doi.org/10.2139/ssrn.1344915

Contact Information

Hui Chen
Massachusetts Institute of Technology ( email )
50 Memorial Drive
Cambridge, MA 02142
United States
617-324-3896 (Phone)
National Bureau of Economic Research (NBER) ( email )
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Scott Joslin (Contact Author)
University of Southern California ( email )
Marshall School of Business
Los Angeles, CA 90089
United States
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References:  114
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