Pricing Path-Independent Payoffs with Exotic Features in the Fractional Diffusion Model

Abstract

We provide several practical formulas for pricing path-independent exotic instruments (log options and log contracts, digital options, gap options, power options with or without capped payoffs …) in the context of the fractional diffusion model. This model combines a tail parameter governed by the space fractional derivative, and a subordination parameter governed by the time-fractional derivative. The pricing formulas we derive take the form of quickly convergent series of powers of the moneyness and of the convexity adjustment; they are obtained thanks to a factorized formula in the Mellin space valid for arbitrary payoffs, and by means of residue theory. We also discuss other aspects of option pricing such as volatility modeling, and provide comparisons of our results with other financial models.

Keywords

• fractional diffusion equation
• subordination
• exotic options
• volatility modeling