Let the (log-)prices of a collection of securities be given by a d-dimensional Lévy process Xt having infinite activity and a smooth density. The value of a European contract with payoff g(x) maturing at T is determined by E[g(XT)]. Let be a finite activity approximation to XT, where diffusion is introduced to approximate jumps smaller than a given truncation level ∈ > 0. The main result of this work is a derivation of an error expansion for the resulting model error, , with computable leading order term. Our estimate depends both on the choice of truncation level ∈ and the contract payoff g, and it is valid even when g is not continuous. Numerical experiments confirm that the error estimate is indeed a good approximation of the model error.
Using similar techniques we indicate how to construct an adaptive truncation type approximation. Numerical experiments indicate that a substantial amount of work is to be gained from such adaptive approximation. Finally, we extend the previous model error estimates to the case of Barrier options, which have a particular path dependent structure.
© de Gruyter 2011