An inverse problem of reconstructing option drift rate from market observation data

Abstract

Drift rate is a very important parameter in the evolution of stock price, which has significant impact on the corresponding option pricing. This paper deals with an inverse problem of recovering the drift function by current market prices of options. Different from the usual inverse volatility problem, our mathematical model does not tend to zero at infinity, which may bring great trouble to theoretical analysis and numerical calculation. To overcome this difficulty, we use an artificial boundary and homogenization technique to transform the original problem into a homogeneous initial boundary value problem on a bounded domain. Then, based on the optimal control framework, we construct the corresponding optimization problem and strictly prove the well-posedness of the minimizer. Finally, we design an iterative algorithm to obtain the numerical solution. We give some typical examples to verify the validity of our method.