On Two Transform Methods for the Valuation of Contingent Claims

Abstract

This paper presents two transform methods for pricing contingent claims namely the fast Fourier transform method and the fast Hilbert transform method. The fast Fourier transform method utilizes the characteristic function of the underlying instrument’s price process. The fast Hilbert transform method is obtained by multiplying a square integrable function f by an indicator function associated with the barrier feature in the real domain. This is also obtained by taking the Hilbert transform in the Fourier domain. We derived closed-form solutions for European call options in a double exponential jump-diffusion model with stochastic volatility. We developed fast and accurate numerical solutions by means of the Fourier transform method. The comparison of the probability densities of the double exponential jump-diffusion model with stochastic volatility, the Black-Scholes model and the double exponential jump-diffusion model without stochastic volatility showed that the double exponential jump-diffusion model with stochastic volatility has better performance than the two other models with respect to pricing long term options. An analysis of the fast Fourier transform method revealed that the volatility of volatility σ and the correlation coefficient ρ have significant impact on option values. It was also observed that these parameters σ and ρ have effect on long-term option, stock returns and they are also negatively correlated with volatility. These negative correlations are important for contingent claims valuation. The fast Fourier transform method is useful for empirical analysis of the underlying asset price. This method can also be used for pricing contingent claims when the characteristic function of the return is known analytically. We considered the performance of the fast Hilbert transform method and Heston model for pricing finite-maturity discrete barrier style options under stochastic volatility and observed that the fast Hilbert transform method gives more accurate results than the Heston model as shown in Table 3.