Working Paper

Path-dependent option valuation when the underlying path is discontinuous

Abstract: The payoffs of path-dependent options depend not only on the final values, but also on the sample paths of the prices of the underlying assets. A rigorous modeling of the underlying asset price processes which can appropriately describe the sample paths is therefore critical for pricing path-dependent options. This paper allows for discontinuities in the sample paths of the underlying asset prices by assuming that these prices follow jump diffusion processes. A general yet tractable approach is presented to value a variety of path-dependent options with discontinuous processes. The numerical examples show that ignoring the jump risk may lead to serious biases in path-dependent option pricing.

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 1997

Number: 1997-16