Completion, pricing and calibration in a Lévy market model

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2010

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Yılmaz, Büşra Zeynep

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In this thesis, modelling with Lévy processes is considered in three parts. In the first part, the general geometric Lévy market model is examined in detail. As such markets are generally incomplete, it is shown that the market can be completed by enlarging with a series of new artificial assets called “power-jump assets” based on the power-jump processes of the underlying Lévy process. The second part of the thesis presents two different methods for pricing European options: the martingale pricing approach and the Fourier-based characteristic formula method which is performed via fast Fourier transform (FFT). Performance comparison of the pricing methods led to the fact that the fast Fourier transform produces very small pricing errors so the results of both methods are nearly identical. Throughout the pricing section jump sizes are assumed to have a particular distribution. The third part contributes to the empirical applications of Lévy processes. In this part, the stochastic volatility extension of the jump diffusion model is considered and calibration on Standard&Poors (S&P) 500 options data is executed for the jump-diffusion model, stochastic volatility jump-diffusion model of Bates and the Black-Scholes model. The model parameters are estimated by using an optimization algorithm. Next, the effect of additional stochastic volatility extension on explaining the implied volatility smile phenomenon is investigated and it is found that both jumps and stochastic volatility are required. Moreover, the data fitting performances of three models are compared and it is shown that stochastic volatility jump-diffusion model gives relatively better results.

Subject Keywords

Lévy processes., Calibration., Pricing.

URI

http://etd.lib.metu.edu.tr/upload/12612598/index.pdf
https://hdl.handle.net/11511/20156

Collections

Graduate School of Applied Mathematics, Thesis

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Citation Formats

B. Z. Yılmaz, “Completion, pricing and calibration in a Lévy market model,” M.S. - Master of Science, Middle East Technical University, 2010.