Orthogonal Polynomials in Pricing Options by the PDE and Martingale Approaches

Suh, Sangwon, Department of Economics, University of Virginia
Epps, Thomas, Department of Economics, University of Virginia
Guidolin, Massimo
Otrok, Christopher, Department of Economics, University of Virginia
Scott, Leonard, Department of Mathematics, University of Virginia

This dissertation discusses two main applications of orthogonal polynomials to various option pricing problems. One application is for solving partial (integro) differential equations; the other is for estimating empirical implied volatility surfaces. The first application, called pseudospectral methods, uses a linear combination of orthogonal polynomials as a trial solution form for the partial (integro) differential equation arising from various option pricing problems. This idea contrasts with finite difference methods, which is the standard numerical partial differential equation solving methods, where a piecewise linear function is assumed as a trial solution. In chapter 2, pseudospectral methods are applied to standard option pricing under various model specifications. Particularly, a way of solving partial integro-differential equations by integrating quadrature method into pseudospectral methods is devised. In addition, forward equations are derived to deliver option prices with different strikes simultaneously. In chapter 3, pseudospectral methods are applied to price several well-known exotic options to check whether the methods are robust in various situations. Pseudospectral methods are found to outperform finite-difference methods when combined with the Broadie-Detemple technique.

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PHD (Doctor of Philosophy)
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