Analytically Pricing Formula for Contingent Claim with Polynomial Payoff under ECIR Process

Abstract

Contingent claims, such as bonds, swaps, and options, are financial derivatives whose payoffs depend on uncertain future real values of underlying assets which emphasize various real-world applications. In general, valuations for contingent claims can be derived from the conditional expectations of underlying assets. For a simple process, the moments are usually directly obtained from its transition probability density function (PDF). However, if the transition PDF is unavailable in simple form, the derivations of the moments and the contingent claim prices will not be accessible in closed forms. This paper provides a closed-form formula for pricing contingent claims with nonlinear payoff under a no-arbitrage principle when underlying assets follow the extended Cox–Ingersoll–Ross (ECIR) process with the symmetry properties of the Brownian motion. The formula proposed here is a consequence of successfully solving an explicit solution for a system of recurrence partial differential equations in which its solution subtly depends on the conditional moments. For the particular CIR process, we obtain simple closed-form formulas by solving the Riccati differential equation. Furthermore, we carry out a complete investigation of the convergent case for those formulas. In case such as that of the unsolvable Riccati differential equation, ECIR case, a numerical method for numerically evaluating the mentioned analytical formulas and numerical validations for the formulas are examined. The validity and efficiency of the formulas are numerically demonstrated by comparison with results from Monte Carlo simulations for various modeling parameters. Finally, the proposed formula is applied to the value contingent claims such as coupon bonds, interest rate swaps, and arrears swaps.

Keywords

• closed-form formula
• conditional expectation
• contingent claim
• ECIR process