A Put-Call Transformation of the Exchange Option Problem under Stochastic Volatility and Jump Diffusion Dynamics

TL;DR

This paper develops a novel method for pricing European and American exchange options under complex stochastic models involving jumps and stochastic volatility, simplifying the problem to a one-dimensional integral transform approach.

Contribution

It introduces a put-call transformation that reduces a two-dimensional exchange option pricing problem to a one-dimensional problem using a specific numeraire choice.

Findings

Derived integral representations for option prices.

Established a system of integral equations for American options.

Analyzed properties of the early exercise boundary.

Abstract

We price European and American exchange options where the underlying asset prices are modelled using a Merton (1976) jump-diffusion with a common Heston (1993) stochastic volatility process. Pricing is performed under an equivalent martingale measure obtained by setting the second asset yield process as the numeraire asset, as suggested by Bjerskund and Stensland (1993). Such a choice for the numeraire reduces the exchange option pricing problem, a two-dimensional problem, to pricing a call option written on the ratio of the yield processes of the two assets, a one-dimensional problem. The joint transition density function of the asset yield ratio process and the instantaneous variance process is then determined from the corresponding Kolmogorov backward equation via integral transforms. We then determine integral representations for the European exchange option price and the early exercise premium and state a linked system of integral equations that characterizes the American exchange option price and the associated early exercise boundary. Properties of the early exercise boundary near maturity are also discussed.