Arithmetic Asian or average price options deliver payoffs based on the average underlying price over a prespecified time period. Asian options are an important family of derivative contracts with a wide variety of applications in currency, equity, interest rate, commodity, energy, and insurance markets. We derive two analytical formulas for the value of the continuously sampled arithmetic Asian option when the underlying asset price follows geometric Brownian motion. We use an identity in law between the integral of geometric Brownian motion over a finite time interval [0, t] and the state at time t of a one-dimensional diffusion process with affine drift and linear diffusion and express Asian option values in terms of spectral expansions associated with the diffusion infinitesimal generator. The first formula is an infinite series of terms involving Whittaker functions M and W. The second formula is a single real integral of an expression involving Whittaker function W plus (for some parameter values) a finite number of additional terms involving incomplete gamma functions and Laguerre polynomials. The two formulas allow accurate computation of continuously sampled arithmetic Asian option prices.
M uch of the work on path-dependent options assumes that the underlying asset price follows geometric Brownian motion with constant volatility. This paper uses a more general assumption for the asset price process that provides a better fit to the empirical observations. We use the so-called constant elasticity of variance (CEV) diffusion model where the volatility is a function of the underlying asset price. We derive analytical formulae for the prices of important types of path-dependent options under this assumption. We demonstrate that the prices of options, which depend on extrema, such as barrier and lookback options, can be much more sensitive to the specification of the underlying price process than standard call and put options and show that a financial institution that uses the standard geometric Brownian motion assumption is exposed to significant pricing and hedging errors when dealing in path-dependent options.
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