A Two-Sided Laplace Inversion Algorithm with Computable Error Bounds and its Applications in Financial Engineering

Abstract

Transform-based algorithms have wide applications in applied probability, but rarely provide computable error bounds to guarantee the accuracy. We propose an inversion algorithm for two-sided Laplace transforms with computable error bounds. The algorithm involves a discretization parameterCand a truncation parameterN. By choosingCandNusing the error bounds, the algorithm can achieve any desired accuracy. In many cases, the bounds decay exponentially, leading to fast computation. Therefore, the algorithm is especially suitable to provide benchmarks. Examples from financial engineering, including valuation of cumulative distribution functions of asset returns and pricing of European and exotic options, show that our algorithm is fast and easy to implement.