Adding and subtracting Black-Scholes: A new approach to approximating derivative prices in continuous-time models

We develop a new approach to approximating asset prices in the context of continuous-time models. For any pricing model that lacks a closed-form solution, we provide a closed-form approximate solution, which relies on the expansion of the intractable model around an “auxiliary” one. We derive an expression for the difference between the true (but unknown) price and the auxiliary one, which we approximate in closed-form, and use to create increasingly improved refinements to the initial mispricing induced by the auxiliary model. The approach is intuitive, simple to implement, and leads to fast and extremely accurate approximations. We illustrate this method in a variety of contexts including option pricing with stochastic volatility, computation of Greeks, and the term structure of interest rates.

► New approach to approximating asset prices in continuous-time models is developed. ► Closed-form approximations are obtained through a series expansion. ► The approach is intuitive, easy to implement, and very precise. ► Numerical examples include option pricing, computation of Greeks, and bond pricing. ► Potential extensions include pricing of exotic contracts and model estimation.