Generalized Transform Analysis of Affine Processes and Applications in Finance

43 Pages Posted: 17 Feb 2009 Last revised: 22 Sep 2011

See all articles by Hui Chen

Hui Chen

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

Scott Joslin

University of Southern California - Department of Finance and Business Economics

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Date Written: September 20, 2011

Abstract

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.

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

JEL Classification: G10, G12, G13, C5

Suggested Citation

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

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 - Department of Finance and Business Economics ( email )

CA
United States

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