Pagliarani S., Pascucci, A., Riga C., SIAM J. Finan. Math., 4(1), 265–296. DOI:10.1137/110858732
36 Pages Posted: 4 Oct 2011 Last revised: 17 Nov 2016
Date Written: October 20, 2011
We propose a novel method for the analytical approximation in local volatility models with Lévy jumps. The main result is an expansion of the characteristic function in a local Lévy model, which is worked out in the Fourier space by considering the adjoint formulation of the pricing problem. Combined with standard Fourier methods, our result provides efficient and accurate pricing formulae. In the case of Gaussian jumps, we also derive an explicit approximation of the transition density of the underlying process by a heat kernel expansion: the approximation is obtained in two ways, using PIDE techniques and working in the Fourier space. Numerical tests confirm the effectiveness of the method.
Keywords: Lévy process, local volatility, analytical approximation, partial integro-differential equation, Fourier methods
JEL Classification: G00, G13
Suggested Citation: Suggested Citation
Pagliarani, Stefano and Pascucci, Andrea and Riga, Candia, Adjoint Expansions in Local Lévy Models (October 20, 2011). Pagliarani S., Pascucci, A., Riga C., SIAM J. Finan. Math., 4(1), 265–296. DOI:10.1137/110858732. Available at SSRN: https://ssrn.com/abstract=1937149 or http://dx.doi.org/10.2139/ssrn.1937149