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Approximation Methods for Inhomogeneous Geometric Brownian Motion

Capriotti, Luca and Jiang, Yupeng and Shaimerdenova, Gaukhar, ''Approximation Methods for Inhomogeneous Geometric Brownian Motion'' (October 8, 2018). International Journal of Theoretical and Applied Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3247379​
Capriotti Luca, Jiang Yupeng, Shaimerdenova Gaukhar
Inhomogeneous Geometric Brownian Motion; Constant Elasticity of Variance; Arrow-Debreu Security, Derivative Pricing; Power Series Expansions
2018
We present an accurate and easy-to-compute approximation of the transition probabilities and the associated Arrow-Debreu (AD) prices for the Inhomogeneous Geometric Brownian Motion (IGBM) model for interest rates, default intensities or volatilities. Through this procedure, dubbed exponent expansion, transition probabilities and AD prices are obtained as a power series in time to maturity. This provides remarkably accurate results — for time horizons up to several years — even when truncated after the first few terms. For farther time horizons, the exponent expansion can be combined with a fast numerical convolution to obtain high-precision results.​