Distribution Approach to Local Volatility for European Options in the Merton Model with Stochastic Interest Rates
Year: 2025
Type: article
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.
Source: Entropy
DOI: 10.3390/e27030320
Authors: Piotr Nowak, Dariusz Gatarek
Institutions: Systems Research Institute, Polish Academy of Sciences
Language: English
Subfield: Finance
Domain: Social Sciences
Open Access status: gold
Estimated APC paid: $3,137
OpenAlex ID: W4408621420