PT - JOURNAL ARTICLE
AU - Carr, Peter
AU - Itkin, Andrey
TI - Semi-Analytical Solutions for Barrier and American Options Written on a Time-Dependent Ornstein–Uhlenbeck Process
AID - 10.3905/jod.2021.1.133
DP - 2021 Apr 12
TA - The Journal of Derivatives
PG - jod.2021.1.133
4099 - http://jod.pm-research.com/content/early/2021/04/12/jod.2021.1.133.short
4100 - http://jod.pm-research.com/content/early/2021/04/12/jod.2021.1.133.full
AB - In this article, we develop semi-analytical solutions for the barrier (perhaps, time-dependent) and American options written on the underlying stock that follows a time-dependent Ornstein–Uhlenbeck process with a lognormal drift. Semi-analytical means that given the time-dependent interest rate, continuous dividend and volatility functions, one need to solve a linear (for the barrier option) or nonlinear (for the American option) Volterra equation of the second kind (or a Fredholm equation of the first kind). After that, the option prices in all cases are presented as one-dimensional integrals of combination of the preceding solutions and Jacobi theta functions. We also demonstrate that computationally our method is more efficient than the backward finite difference method traditionally used for solving these problems, and can be as efficient as the forward finite difference solver while providing better accuracy and stability.TOPICS: Derivatives, options, statistical methodsKey Findings▪ For the first time the method of generalized integral transform, invented in physics for solving an initial-boundary value parabolic problem at [0, y(t)] with a moving boundary [y(t)], is applied to finance.▪ Using this method, pricing of barrier and American options, where the underlying follows a time-dependent OU process (the Bachelier model with drift) are solved in a semi-analytical form.▪ It is demonstrated that computationally this method is more efficient than the backward and even forward finite difference method traditionally used for solving these problems whereas providing better accuracy and stability.