 Journal of Mathematical Finance, 2014, 4, 1-9 Published Online January 2014 (http://www.scirp.org/journal/jmf) http://dx.doi.org/10.4236/jmf.2014.41001 OPEN ACCESS JMF Evaluation of Geome tric Asian Power Options under Fractional Brownian Motion Zhijuan Mao1, Zhian Liang2 1School of Finance, Shanghai University of Finance and Economics, Shanghai, China 2Department of Applied Mathematics, Shanghai University of Finance and Economics, Shanghai, China Email: zmao86@gmail.com Received October 12, 2013; revised November 21, 2013; accepted December 6, 2013 Copyright © 2014 Zhijuan Mao, Zhian Liang. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. In accordance of the Creative Commons Attribution License all Copyrights © 2014 are reserved for SCIRP and the owner of the intellectual property Zhijuan Mao, Zhian Liang. All Copyright © 2014 are guarded by law and by SCIRP as a guardian. ABSTRACT Modern option pricing techniques are often considered among the most mathematical complex of all applied areas of financial mathematics. In particular, the fractional Brownian motion is proper to model the stock dy- namics for its long-range dependence. In this paper, we evaluate the price of geometric Asian options under frac-tional Brownian motion framework. Furthermore, the options are generalized to those with the added feature whose payoff is a power function. Based on the equivalent martingale theory, a closed form solution has been derived under the risk neutral probability. KEYWORDS Fractional Brownian Motion; Geome tric Asian Options; Closed-Form Solution; Risk-Free Rate 1. Introduction Estimating option pricing is a central topic in financial mathematics. A call (put) option is a contract which gives the holder the right but not the obligation, to buy (sell) a risky asset at a certain date with a predetermined price (called strike price). In terms of the execution time, options can be classified into three types: American options whose owner can choose to exercise at any time up to and including the expiration; Bermudan options which permit early exercise but only on a contractually specified finite set of dates; European options which can only be exercised at the expiration date. The European calls and puts, which are with maturity T and strike price K, are often called vanilla options. And their payoffs at maturity, i.e., ST K and KST, respectively, depend only on the spot value of the underlying asset. On the other hand, there exist several kinds of exotic options such as Asian options, look-back options and knock-out options. In 1987, Asian options were first introduced at a branch of an American bank in Tokyo, Japan. For an Asian option, its payoff is determined by the average value over some predetermined time interval. One advantage is that it can reduce the risk of market manipulation of the underlying instrument at maturity. Moreover, they offer better hedging possibilities for firms with a stream of exposures. Another benefit is that they are useful in pro-tecting the owner from sudden short lasting price changes in the market, for example, due to order imbalances . Because of the averaging property, Asian options reduce the volatility inherent in the option. And therefore, Asian options are usually cheaper comparing with its European counterparts. Asian options have numerous permutations, such as fixed and floating strike price options. The payoff of fixed strike options is ATK, KAT for a call and put option, respectively, where K denotes the strike price and AT is the average price of the underlying asset. For floating strike price options, the payoff takes the following form: STAT and  AT ST for a call and put option, respectively. In terms of the average price AT, Asian options can be classified into two categories: arithmetic average Z. J. MAO, Z. LIANG 2 Asians and geometric average Asians, and both these forms can be averaged on a weighted average basis. For the continuous case, arithmetic average is obtained by  01d.TATStTt And the geometric average is given by 01ln de. (1) TSt tTAT For the discrete case, we just need to change the integral into summation. In this sequel, we just consider the case of continuous geometric average with fixed strike price and leave the discrete case for readers. An Asian option (also called average value option) is an important class of path-dependent options and its pricing has aroused much attention. The path integral formalism was created by Richard Feynman in quantum physics . Norbert Wiener used this type of integral in his research of Brownian motion . And Jan Dash first introduced this type of path integral into finance, who developed empirical studies related to the Black-Scholes- Merton model and the one-factor term structure constrained model. Till now, there is no known closed form so-lution for the arithmetic type, for it is difficult to analytically evaluate the sum of the related log-normal random variables. Feynman and Kleinert showed that by the method of the path integral, the problem for geometric av-erage can be solved via the effective classical potential . In 1990, Kemna and Vorst discussed the pricing of arithmetic Asian options with MCMC method and proposed Turnbull and Wakeman formula for pricing Arith-metic average option under continuous case. Furthermore, they derived an analytic solution for a geometric av-erage option by changing the diffusion term . In 1995, Rogers and Shi solved the pricing problem with a PDE approach . On the other hand, the introduction of fractional Brownian motion (FBM) should date back to the develop-ment of the option pricing theory. In 1900, Bachelier, the father of option pricing theory, first developed arith-metic Brownian motion to model the dynamics of underlying asset . In 1973, F. Black and M. Scholes intro-duced the Black-Scholes-Merton (BSM) model, which assumed that the stock process followed a geometric Brownian motion. And they derived the well-known BS formula . But empirical studies indicate that the log-returns are usually not normal and show the dependence structure. Additionally, it also reveals that the stock price usually has some properties such as “fat tail”, “self-similarity”, “long-range dependence” . This reveals the disparity between the model and the market. In 1940, Kolmogorov first introduced the fractional Brownian motion within a Hilbert space, where it was called Wiener Helix. Yaglom studied this process and discussed its moment properties . Further studies have discovered that fractional Brownian motion can be used to model such situations as 1) The widths of consecutive annual rings of a tree; 2) The temperature at a specific place as a function of time; 3) The level of water in a river as a function of time; 4) The characters of solar activity as a function of time; 5) The values of the log returns of a stock; 6) Financial turbulence, i.e., the empirical volatility of a stock, and other turbulence phenomena; 7) The prices of electricity in a liberated electricity market. In 1968, Mandelbrot and Van Ness provided a stochastic integral representation of this process: If 0 < H < 1, the fractional Brownian motion with Hurst index H is a continuous Gaussian process, , and 00HHBttRB with mean zero and covariance: 22 21., 2HHHHtsosCts tv Obviously, HBt coincides with B(t), the standard Brownian motion, when 12H. In 2008, Ciprian Necula obtained an explicit fractional BS formula by using Fourier transform . Mandelbrot and Taylor pro-posed that the stock market should take on the character of fractional Brownian motion . Then Peters intro-duced fractional Brownian motion to model the dynamics of stock price . After this, many scholars have made outstanding contributions on this topic. In 2000, Duncan et al., Hu and Oksendal developed the fractional OPEN ACCESS JMF Z. J. MAO, Z. LIANG 3BS formula by using Wick-product . And the systematic option pricing theory under fractional Brownian motion framework has been presented by Hu et al. in . The paper is organized as follows. In Section 2, we further give a simple description of fractional Brownian motion framework and review some existing results of power options. Next, the pricing model of Geometric Asian power options has been presented in Section 3. Moreover, closed form solution and call-put parity are also derived. The conclusion remarks and some open problems are discussed in the final part. 2. Preliminary In general, one can rely on the numerical methods for pricing arithmetic Asian options in Levy models . While geometric averaging options within Levy models can be priced analytically. Since its statistical property can be obtained from the assumption that the stock process follows a log-normal distribution. Kemna and Vorst  derived an analytic formula for Asian options of this kind as below. Lemma 2.1 For a geometric average Asian call option, its payoff is given as ATK, where K is the strike price and 001ln deTTSttTTAT  with 0,TT being the final time interval over which the average value of the stock is calculated. Then AT is log-normally distributed and thus the value of the option at time is as following: 0T200112600 012,e erTT rT TNNCSTTSTF dKF d  , where  02012011ln 126 and .313ST rTTKddTT  10dTT In the FBM framework, stock is assumed to be the underlying asset and denoted by S(t) for simplicity. Then the price process can be modeled by the following PDE:  dddHSt tBtSt , (2) where is the spot price of the underlying security at time t, St , are both constant, HBt being the standard FBM. Under risk neutral probability, (2) turns into the following form:  dddHSt rtB tSt, (3) where r is the risk-free rate and HBt is the FBM under the new measure. The corresponding fractional BS formula was developed in [13,17]. For a European call option, its price process ,CSt t satisfies the fol-lowing PDE: 2222 120.HCCCHS trSrCStS Solving the above PDE obtains the pricing formula: 120,00,NNCSSFdKF d where NF denotes the cumulative distribution function of standard normal distribution with 22120ln 2,.H1HHSrT TKddTdT Furthermore, Biagini and Oksendal etc. extended the model by assuming that the risk-free rate and dividend rate are non-random functions . Then the option pricing formula under FBM framework is given as below: OPEN ACCESS JMF Z. J. MAO, Z. LIANG 4 Lemma 2.2 Suppose the dynamics of asset price follows PDE (3) under the risk neutral probability. If the risk-free rate rt and dividend rate qt are non-random functions and the payoff function at maturity ,fSTT is bounded, then the price of a European option ,VSt t satisfies the following:  222 22 21dd221,ee ed2πTHH HHTttxrsqssT tT txrs sVSt tf Stx. Recently, kinds of derivatives have been introduced to satisfy the need of market. Power options, one kind of the newly developed options, have aroused more and more attention. They are used to change the return struc-ture and also possess more flexibility comparing with vanilla options. Power options can be seen as instruments of risk management and getting higher return, thus attracting more and more application. For a European power call, there exist two types in terms of different payoff functions: if ,if nnnST KSTKfST TST KSTK, where n is a positive number. In 2005, Y. Wang et al.  derived an explicit formula of European power options. And Y. Xiao et al.  studied some properties of power options under Brownian motion framework. D. In 2006, Y. Wang et al.  generalized the model to Geometric Asian power options and obtained the solution under continuous case. In this paper, we further extend the underlying asset follows a fractional Brownian motion. Zhao  and S. Zhou  considered the European power options under FBM framework and deduced the pricing formula and call- put parity as well. In this paper, we consider the Asian power options under FBM framework. Correspondingly, for an Asian power call option with fixed strike price K and maturity T, there exist two types of payoff functions: if (4),if (5)nnnAT KATKfATT AT KATK, where AT is defined as (1). We discuss the case of (4), since the results for the other type can be obtained by the same procedure. 3. Pricing Model 3.1. General Hypotheses The general assumptions in this model are as below: A1 The dynamics of underlying asset follows fractional Brownian motion. A2 The risk-free rate r(t) is non-random function. A3 There are no transaction costs or taxes in buying or selling stocks, options, i.e., the market is frictionless. A4 Dividends are paid on the underlying stock during the option life with the rate of q(t). A5 The option can only be exercised at maturity. A6 The market does not admit arbitrage. 3.2. Pricing Framework with Constant Risk Free Rate and Dividend Rate Before coming to the case of non-random risk-free rate, we first consider the case that the risk-free rate and dividend rate are both constant. Let for simplicity. Under above assumptions, the dynamics of stock price process (3) takes the following form under risk neutral measure: 0t  dddHSt rqtBtSt , where r, q are the risk-free rate and dividend rate, respectively, HBt being the FBM under risk-neutral probability. Then the stock price process can be derived OPEN ACCESS JMF Z. J. MAO, Z. LIANG 52210exp .2HHStSr qttBt It implies that is log-normally distributed with St22 221lnln 0,2HHStNSr qttt under risk neutral measure. First, we derive the closed form solution for Geometric Asian options with fixed strike price. Since its payoff at maturity is ATK, the following theorem is derived: Theorem 3.1 Suppose the dynamics of underlying asset follows PDE (3) under risk neutral probability. If the risk free rate rt and dividend rate qt are constant, then a Geometric Asian call option at time 0t is priced as below:   221124211120, 0ee,HrqT THH rTNNCSTSF dKF d   where   22212011ln 2221and .21 21HHHSrqT TKH TddTH H d (6) Proof of Theorem 3.1 Define  01ln dTGTSttT and exp .ATGT From the definition, GT is normally distributed with mean  and variance 2, which are calculated explicitly as below.     02200221ln d11ln 0dd211ln 02221TTTHHEGTESt tTSrqtttTTSrqT THt and  22220022002222 2 1dd1dd2121TTHHTTHHHHVarG TEG TEB tBttsTtsTTHt, where E denotes the expectation under risk neutral probability. Consequently, we can conclude that AT is log-normally distributed, i.e., 2ln, .AT GT N.K For a geometric Asian option, its payoff at maturity is Hence under the risk neutral measure, the value of a call option is: expAT KGT22210, eeeed,2πxrTrTxDCSTE ATKKx where ::ex.DxAT KxK And simple computations lead to that: OPEN ACCESS JMF Z. J. MAO, Z. LIANG 6     2222222222 222222 222211 12221 4112112421111eeed eedeed2π2π2π1eede2π0e e0e0,HHyy yrTrT yrTDdyrT rT NdrqT TTHH rTNNrqT THH221dKyyKyK FdSFdKFdSCS T        12eHrTNNFdK Fdy, where   22::e:0ln 2221:211yHHDxATKyKy yKSrqT TKHyy TH  ln and are defined as (6). ,1,2idiThe Theorem is proved. Moreover, by the same procedure, we can conclude that under FBM, the price of a Geometric Asian put op-tion is valued at:  221124211210, e0e,HrqT THHrT NNPST K FdSFd  where are defined same as Theorem 3.1. ,1,2idiNext, we extend the options to Geometric Asian power ones and obtain the following results: Theorem 3.2 Suppose the dynamics of underlying asset follows PDE (3) under risk neutral probability. If the risk free rate rt and dividend rate qt are constant and the payoff function at maturity is given as (4). Then the price of a Geometric Asian power call, 0,CST , is obtained:    222 222221 41120, 0eeHHnn nrTrq TTTHHnrTNNCSTSF DKF D    where    22212011ln 2221and .21 21HHnHSrqT THKnDDTH H TD (7) Proof of Theorem 3.2 For the power option discussed in Theorem 3.2, its payoff at the maturity is expnAT KnGTK . Based on Theorem 3.1, the closed form solution is deduced as below:    222222222222222222222122221 41110,eee deedee d2π2π2π1eede2πee0eHHyynynyrTrT nrTDDynnrT nrT NDnrT nrTNNnn nrTrqTTTHHnCSTKyy KyyK FDFD K FDSF       12erTNNDKFD221yD where OPEN ACCESS JMF Z. J. MAO, Z. LIANG 7  22::e:0ln 2221:211nny nHnHDxATKyKyy KSrqT THKyy TH  ln and are defined as (7). ,1,2iDiThe proof is complete. Furthermore, similar procedure obtains the price of the corresponding put option:   222 222221 412 10, e0e,HHnn nrTrq TTTHHrT nPSTKN DSN D    where are defined same as Theorem 3.2. ,1,2iDi3.3. Generalized Pricing Framework Finally we consider the case that the risk-free rate and dividend rate are non-random functions. Under the risk neutral measure, the dynamics of stock price is obtained 22010exp d.2tHHStSrsqsstBt Thus we obtain that is log-normally distributed and St 22 2201lnln 0d,.2tHHStNSrs qsstt Consider that AT is defined as (1), and we denote 2ln, .AT N Simple computations lead to    220022211ln0dd,22 11.21TtHHSTrsqHTTH sst Furthermore, the desired formula of option price can be derived as below:     202200222220022200d2dd22dd222dd21210,eee d2π11eedeed2π2π1eede2πee0eTTTTTTTyrs snyDyynyrs snrs sDDynnrss nrssNDnrss nrs sNNnCS TKyyK yyK FdFD KFDS      22 222000 0ddd d22 14112e,HHTTt TnnTnTrs srsqsstrssTHHNNFD KFD  where    2201220011lnd d22 1and .21 21TtHHnHSTrsqsstHTKnDDTHH TD (8) As for the geometric Asian power put option, its price takes the following form: OPEN ACCESS JMF Z. J. MAO, Z. LIANG 8   22 2220000dddd22 1412 10, e0e,HHTTtTnnTnTrs srsqsstrs sTHHnN NPSTKF D SF D   where are defined as (8). ,1,2iDiRemark: Theorem 3.2 is just a particular case of the conclusions in . And the Geometric Asian options are just the case of . Finally, the call-put parity can also be obtained for Geometric Asian power options. 1nTheorem 3.3 Suppose the dynamics of underlying asset follows PDE (3) under risk neutral probability. If the risk free rate rt and dividend rate qt are constant and the payoff function at maturity is given as (4). Then its call-put parity is as below:   222 222221 410,0,0ee .HHnnnrTrq TTTHH rTCS TPS TSK    Moreover, for the case of non-random functions of rt and qt, the following holds:   22 2220000ddd d22 1410,0,0ee .HHTTt TnnTnTrs srsqsstrssTHHnCS TPS TSK    Here we omit the proof and leave it for readers. 4. Conclusions In this paper, we first consider the geometric Asian options with constant risk-free rate and dividend rate under FBM, and derive the call-put parity. Furthermore, we discuss the geometric Asian power options. Finally, for the general case of non-random risk-free rate and dividend rate, we obtain the corresponding pricing formulas and call-put parity. If 12H, FBM is Brownian motion and all the conclusions coincide with that of classical ex- ponential Brownian motion framework . If 1n, the solutions are the same as the results in BSM model . For the Asian option with floating strike price, its pricing is of great interest in our future study. For the arithmetic Asian option, the statistical property is not as well as that of geometric kind. Therefore, our future focus will be on how to use numerical method to study its properties. Moreover, another interest is to calibrate the model with market data. 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