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Differential equations and asymptotic solutions for arithmetic Asian options: ‘Black–Scholes formulae’ for Asian rate calls

Published online by Cambridge University Press:  01 August 2008

J. N. DEWYNNE  and
W. T. SHAW
J. N. DEWYNNE
Affiliation:
OCIAM, The Mathematical Institute, 24-29 St Giles, Oxford OX1 3LB, UK email: dewynne@maths.ox.ac.uk
W. T. SHAW
Affiliation:
Mathematics Department, King's College, London WC2R 2LS, UK email: william.shaw@kcl.ac.uk
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Abstract

In this article, we present a simplified means of pricing Asian options using partial differential equations (PDEs). We first provide a concise derivation of the well-known similarity reduction and exact Laplace transform solution. We then analyse the problem afresh as a power series in the volatility-scaled contract duration, with a view to obtaining an asymptotic solution for the low-volatility limit, a limit which presents difficulties in the context of the general Laplace transform solution. The problem is approached anew from the point of view of asymptotic expansions and the results are compared with direct, high precision, inversion of the Laplace transform and with numerical results obtained by V. Linetsky and J. Vecer. Our asymptotic formulae are little more complicated than the standard Black–Scholes formulae and, working to third order in the volatility-scaled expiry, are accurate to at least four significant figures for standard test problems. In the case of zero risk-neutral drift, we have the solution to fifth order and, for practical purposes, the results are effectively exact. We also provide comparisons with the hybrid analytic and finite-difference method of Zhang.

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Type
Papers
Information
European Journal of Applied Mathematics , Volume 19 , Issue 4 , August 2008 , pp. 353 - 391
Copyright
Copyright © Cambridge University Press 2008

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