Limit theorems for prices of options written on semi-Markov processes

TL;DR

This paper derives limit theorems for European option prices on semi-Markov processes, showing convergence to time-changed Brownian motion prices and generalizing Black-Scholes with fractional calculus.

Contribution

It introduces new limit theorems for option prices on semi-Markov processes and extends Black-Scholes to fractional models with inverse subordinator time changes.

Findings

Option prices converge to those on geometric Brownian motion with inverse stable subordinator.

Derived a renewal equation for martingale option prices.

Generalized Black-Scholes equation using time-fractional calculus.

Abstract

We consider plain vanilla European options written on an underlying asset that follows a continuous time semi-Markov multiplicative process. We derive a formula and a renewal type equation for the martingale option price. In the case in which intertrade times follow the Mittag-Leffler distribution, under appropriate scaling, we prove that these option prices converge to the price of an option written on geometric Brownian motion time-changed with the inverse stable subordinator. For geometric Brownian motion time changed with an inverse subordinator, in the more general case when the subordinator's Laplace exponent is a special Bernstein function, we derive a time-fractional generalization of the equation of Black and Scholes.