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Analytical approximation for spread option pricing in local volatility model

Ying Yang

Department of Physics, Tsinghua University, Beijing, China

E-mail Address: yangying13@tsinghua.org.cn

https://doi.org/10.1142/S2424786317500220Cited by:0 (Source: Crossref)

Abstract

This paper introduces a methodology of analytical approximation in general European option-pricing case based on local volatility model and then apply it to price a European Spread Option. The approximation procedure is flexible in pricing financial derivatives with any form of volatility, drift rate, risk-free rate and payoff function. We also work out the explicit pricing formula up to the second-order approximation of spread option which is good-fitting compared with finite difference method and Monte Carlo simulation. The relative error compared to finite difference method is no more than 5%, which attests to the accuracy of our second-order closed-form formulas.

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