Bessel Processes, Asian Options, and Perpetuities

Abstract

Using Bessel processes, one can solve several open problems involving the integral of an exponential of Brownian motion. This point will be illustrated with three examples. The first one is a formula for the Laplace transform of an Asian option which is “out of the money.” The second example concerns volatility misspecification in portfolio insurance strategies, when the stochastic volatility is represented by the Hull and White model. The third one is the valuation of perpetuities or annuities under stochastic interest rates within the Cox-Ingersoll-Ross framework. Moreover, without using time changes or Bessel processes, but only simple probabilistic methods, we obtain further results about Asian options: the computation of the moments of all orders of an arithmetic average of geometric Brownian motion; the property that, in contrast with most of what has been written so far, the Asian option may be more expensive than the standard option (e.g., options on currencies or oil spreads); and a simple, closed-form expression of the Asian option price when the option is “in the money,” thereby illuminating the impact on the Asian option price of the revealed underlying asset price as time goes by. This formula has an interesting resemblance with the Black-Scholes formula, even though the comparison cannot be carried too far.