Compound option pricing under a double exponential Jump-diffusion model

Abstract

A compound option, an option on another option, plays an important role in financial field since it can be used to price American option and corporate debt with discrete coupons. In the real options literature, compound options are most suitable to be employed to investment problems involving sequential decision making. Most compound option and real options formulae are based on log-normal distribution while the empirical evidence shows that the return distribution in real market exhibits asymmetric leptokurtic feature, higher peak and two heavier tails. This paper introduces the jump-diffusion process into pricing compound options and derives the related valuation formulas. We assume that the dynamic of the underlying asset return process consists of a drift component, a continuous Wiener process and discontinuous jump-diffusion processes which have jump times that follow the compound Poisson process and the logarithm of jump size follows the double exponential distribution proposed by Kou (2002). Numerical results indicate that the advantage of combining the double exponential distribution and normal distribution is that it can capture the phenomena of both the asymmetric leptokurtic features and the volatility smile. Furthermore, the compound options under the double exponential jump diffusion model which we derived are more generalized than those proposed by Gukhal (2004) and Geske (1979), and thus have wider application.