Distribution Approach to Local Volatility for European Options in the Merton Model with Stochastic Interest Rates

The Dupire formula is a very useful tool for pricing financial derivatives. This paper is dedicated to deriving the aforementioned formula for the European call option in the space of distributions by applying a mathematically rigorous approach developed in our previous paper concerning the case of the Margrabe option. We assume that the underlying asset is described by the Merton jump-diffusion model. Using this stochastic process allows us to take into account jumps in the price of the considered asset. Moreover, we assume that the instantaneous interest rate follows the Merton model (1973). Therefore, in contrast to the models combining a constant interest rate and a continuous underlying asset price process, frequently observed in the literature, applying both stochastic processes could accurately reflect financial market behaviour. Moreover, we illustrate the possibility of using the minimal entropy martingale measure as the risk-neutral measure in our approach.

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Publication Details

Journal
Entropy
Published
2025-03-19
DOI
https://doi.org/10.3390/e27030320
Primary Topic
Stochastic processes and financial applications
Type
article
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article

Distribution Approach to Local Volatility for European Options in the Merton Model with Stochastic Interest Rates

Dariusz Ga̧tarek, Piotr Nowak
Entropy
Stochastic processes and financial applications
article

Distribution Approach to Local Volatility for European Options in the Merton Model with Stochastic Interest Rates

Dariusz Ga̧tarek, Piotr Nowak
article en

Abstract

The Dupire formula is a very useful tool for pricing financial derivatives. This paper is dedicated to deriving the aforementioned formula for the European call option in the space of distributions by applying a mathematically rigorous approach developed in our previous paper concerning the case of the Margrabe option. We assume that the underlying asset is described by the Merton jump-diffusion model. Using this stochastic process allows us to take into account jumps in the price of the considered asset. Moreover, we assume that the instantaneous interest rate follows the Merton model (1973). Therefore, in contrast to the models combining a constant interest rate and a continuous underlying asset price process, frequently observed in the literature, applying both stochastic processes could accurately reflect financial market behaviour. Moreover, we illustrate the possibility of using the minimal entropy martingale measure as the risk-neutral measure in our approach.

EntropyVol. 27(3)
Systems Research Institute (PL), Polish Academy of Sciences (PL)
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Openalex Percentile: Top 93%
Stochastic processes and financial applications
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