Jump-Diffusion Models

where F is the risk-neutral jump distribution. The

jump compensator is then given by
Z
Jump-diffusion (JD) models are particular cases of
exponential Levy models in which the frequency of
J =
F (d)
jumps is finite. They can be considered as prototypes for a large class of more complex models To simplify the presentation, we henceforth assume
such as the stochastic volatility plus jumps model zero dividends so that
= r, the risk-free rate.
of Bates [1].
Consider a market with a riskless asset (the Characteristic Function
bond) and one risky asset (the stock) whose price
rT
at time t is denoted by St . In a JD model, the SDE Define the forward price F := S0 e . If xt :=
log St /F ) is a Levy
its characteristic funcfor the stock price is given as
 process,

tion T (u) := E eiuxT has the Levy-Khintchine
dSt = St dt + St dZt + St dJt
(1) representation
n
T (u) = exp i u (J 2 /2) T u2 2 /2 T
where Zt is a Brownian motion and
Z
o
 iu

Nt
X
+T
e 1 () d .
(3)
Yi
Jt =
i=1
Typical assumptions for the distribution of jump
is a compound Poisson process where the jump sizes sizes are: normal as in the original paper by Merton
Yi are independent and identically distributed with [6] and double-exponential as in Kou [4]. In the
distribution F and the number of jumps Nt is a Merton model, the Levy density () is given by


Poisson process with jump intensity . The as( )2

exp

()
=
set price St thus follows geometric Brownian mo2 2
2
tion between jumps. Monte Carlo simulation of
the process can be carried out by first simulating where is the mean of the log-jump size log J and
the number of jumps Nt , the jump times, and then the standard deviation of jumps. This leads to
simulating geometric Brownian motion on intervals the explicit characteristic function

between jump times.
1

(u)
=
exp
i u T u2 2 T
T
The SDE (1) has the exact solution:
2




2 2
St = S0 exp t + Zt 2 t/2 + Jt
(2)
+ T ei u u /2 1
Merton [6] considers the case where the jump sizes
Yi are normally distributed.

In the double-exponential case



() = p + e+ 10 + (1 p) e 1<0

Risk-neutral drift

where + and are the expected positive and

If the above model is used as a pricing model, the negative jump sizes respectively and p is the reladrift in (1) is given by the risk-neutral drift
tive probability of a positive jump. This gives the
explicit characteristic function
plus a jump compensator J :

1
T (u) = exp i u T u2 2 T
=
+ J
2


p
1p
To identify J , taking expectations of equation (1)
+ T

+ i u + i u
and from the definition of
,
E[dSt ]

with

St dt = St dt
Z

+
F (d) St dt

1
= 2
2
1

p
1p

+ + 1 1

Pricing of European options

with

log(S/K) + r T
T

d1 =
+
;
2
T

log(S/K) + r T
T

d2 =
;

2
T

Given a characteristic function, European call options can be priced using Fourier methods as in
Lewis [5]:
C(S, K, T )

Z

1 du
r T
=e
F FK
0 u2 +



Re eiuk T (u i/2)

Jump to Ruin

1
4

In the case where eYi = 0 with probability 1, J =

and equation (6) simplifies to

(4)

C(S, K, T ) = e T CBS (S e T , K, r, , T )

where the log-strike k := log (K/F ).

(7)

which is the Black-Scholes formula with a shifted

interest rate r r + . This special case of the
Assuming the process (1), and a constant risk-free JD model where the stock price jumps to zero (or
rate r, and further supposing that the market is ruin) whenever there is a jump, is the simplest poscomplete, the value V (S, t) of a European-style op- sible model of default. Equation (7) for the option
price in the jump-to-ruin model may also be derived
tion satisfies:
from a Black-Scholes style replication argument usZ
ing stock and bonds of the issuer of the stock; upon
1 2 2 2V
V
V
+ S
+rS
rV +
F (d)
default of the issuer, both stock and bonds jump to
t
2
S 2
S
n
o
zero. The cost of funding stock with bonds of the


V
V (S e , t) V (S, t) e 1 S
=0
issuer is r + in this picture, which explains the
S
simple
form (7) of the solution.
(5)
Valuation equation

where for ease of notation, V denotes V (S, t). Local volatility

Equation (5) is a partial integro-differential equation (PIDE) which can be solved using finite differ- There is a particulary simple expression for Dupire
local volatility in the jump-to-ruin model. It is
ence methods [2].
given by Gatheral [3]
A Valuation Formula for European Options

2
loc
(K, T ; S) = 2 + 2

Merton [6] derived an exact solution of the valuation equation (5) for a European-style call option
with strike K and time-to-expiration T which has
the form of an infinite sum of Black-Scholes-like
terms:
Z

X
e T ( T )n
C(S, K, T ) =
Fn (d)
n!
n=0

with

N (d2 )
N 0 (d2 )

log(S/K) + T
T

d2 =

;
2
T

As K , d2 and the correction term

vanishes, and as K 0, the correction term explodes. In addition, as the hazard rate increases,
so does d2 , increasing local volatility for low strikes
K relative to high strikes.

CBS (S e eJ T , K, r, , T )
(6)
where Fn is the distribution of the sum of n independent jumps and CBS () denotes the BlackScholes solution, which is given as
CBS (S, K, r, , T ) = S N (d1 ) K er T N (d2 )
2

Normally distributed jumps

[5] Lewis, A.L. (2000) Option Valuation under

Stochastic Volatility with Mathematica Code, FiMerton [6] also shows that if jumps are normally
nance Press, Newport Beach, CA.
distributed with Yi N (, ), equation (6) again
[6] Merton, R.C. (1976) Option pricing when unsimplifies considerably to give
derlying stock returns are discontinuous. J. Financial Economics 3, 125144.
C(S, K, T )
=

X
e T (0 T )n
CBS (S, K, rn , n , T )
n!
n=0

(8)
with
2

e+

n2 T

2 T + n 2

rn T

(r + J ) T + n + 2 /2

/2

Each term CBS (S, K, rn , n , T ) in equation (8) is

the value of the option conditional on there being
exactly n jumps during its life.
Implied volatility smile
If there were no jumps in this model, the implied volatility smile would be flat. Jumps in the
JD stock price process induce an implied volatility
smile whose short time limit (see e.g., [3]) is given
as
2
(K, T ) 2 J as T 0.
K
K BS
The greater J , because jumps are either more frequent or more negatively skewed, the more negative
is the implied volatility skew.

Jim Gatheral.
References
[1] Bates, D. (1996) Jumps and stochastic
volatility: the exchange rate processes implicit in
Deutschemark options. Rev. Fin. Studies 9, 69
107.
[2] Cont, R. and Voltchkova, E. (2005). A finite difference scheme for option pricing in jumpdiffusion and exponential Levy models, SIAM
Journal on Numerical Analysis 43(4), 1596-1626.
[3] Gatheral, J. (2006) The Volatility Surface,
John Wiley & Sons, Hoboken, Chapter 5.
[4] Kou, S. (2002) A jump-diffusion model for option pricing. Management Science 48, 10861101.
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