Option Pricing Using Mixed Discrete and Continuous Processes

Many of the option pricing models being used in academia, the private
sector, and the public sector fall into two categories of models. Some of the
models are based on the assumption that the price movements of the option
and its underlying stock are continuous, while others operate under the
assumption that these quantities are discrete, that they jump between
values. Research into how to accurately model the option price using a
combination of these ideas may be valuable in helping to stabilize the
derivative markets. As the derivative markets stabilize, other markets will
follow suit.
As can be seen in the below visual representation of the Wilshire 5000
over the last fifteen years, it appears that there are periods in which the
market is following continuous models,
and periods where it is difficult to argue
that the market is continuous, such as in
2008. Given the historical data which
supports the idea that stock prices are
not always continuous, it is difficult to
argue that the option prices must also
be always continuous. There have been
studies into combining these discrete
and continuous process for when the
discrete jumps are considered relatively
small, but we must now also consider the possibility for extremely large
jumps such as during the 2008 crisis.
In order to use the classic Black-Scholes option pricing model, one
must assume that the price of the underlying asset is a continuous stochastic
variable, easily modelled by the geometric Brownian motion (Klebaner, 305306). We know, though, that this is a simplified model which will not always
work for the different types of options out there, so new models were
developed to accommodate these. A major step in modelling financial assets
was the use of numerical methods from mathematics to analyze these
problems. One of the tools used to model the price of American options is
using Monte Carlo simulations in order to find an optimal time to exercise an
American put (Brandimarte, 486).
In his 1976 article Option Pricing When Underlying Stock Returns Are
Discontinuous, Robert Merton derives an equation for pricing a European
call option where the returns are not continuous, which can then be
extended into the pricing of corporate liabilities and other financial assets.
One problem with this model is that it does not account for the possibility of
there being large movements in the market (Guegan et al., 2013), where
these movements could be created by world events, be they political,
environmental, or otherwise.
I find the issue of pricing options to be mathematically valuable and
interesting. Being able to accurately price options allows for the accurate

pricing of futures, bonds, and other derivatives with the application of the
same analysis, but with adjustments made depending on the asset under
consideration. If able to conduct this research in the future, I would like to
look at allowing for continuous stochastic variables and discrete stochastic
variables to both occur with varying intensities and frequencies. First, I
would run some numerical simulations on individual companies, eventually
moving towards market indexes, to look at the viability of allowing for the
variables under consideration to be both continuous and discrete at any
given point in time. From here, I would continue to run simulations looking
for patterns, looking for a potential model to implement. This process would
also require a high level of analysis, specifically stochastic analysis, to be
used, in conjunction with the numerical methods being done through a
computer.
As mentioned, this research could help to stabilize the derivative
markets due to the fact that a more accurate pricing model would stabilize
the markets. Other applications of this research could include weather
modelling, portfolio optimization, and biological processes. This research
could provide new mathematical models for a wide variety of fields.
Brandimarte, Paolo. Numerical Methods in Finance and Economics. 2nd ed.
Hoboken, New Jersey: John Wiley & Sons, Inc., 2006.
Guegan, Dominique, Florian Ielpo, and Hanjarivo Lalaharison. "Option Pricing
with Discrete Time Jump Processes." Journal of Economic Dynamics and
Control. 37.12 (2013): 2417-2445.
Klebaner, Fima C. Introduction to Stochastic Calculus with Applications. 3rd
ed. London: Imperial College ;, 2012.
McDonald, Robert L. Fundamentals of Derivatives Markets. Boston: Pearson
Addison Wesley, 2009.
Merton, Robert C. "Option Pricing When Underlying Stock Returns Are
Discontinuous." Journal of Financial Economics. 3.1-2 (1976): 125-144.