On an approximation method for pricing a high-dimensional basket option on assets with mean-reverting prices

Abstract

This study presents a simple but powerful approximation approach that is both accurate and computationally efficient for valuing basket options on multiple assets with mean-reverting prices. It accomplishes this by solving technical problems involved in reducing the dimensionality of basket options. The approach is readily applicable to multi-factor situations where traditional techniques do not work and contributes to the fields of option pricing, computational finance, and energy industry risk management. Numerical examples, including applications to the energy commodity market, illustrate the computational efficiency and accuracy of the approach when compared with results from Monte Carlo (MC) simulations and extant methods in the literature. © 2006 Elsevier Ltd. All rights reserved.