A jump-diffusion model for option pricing

A jump-diffusion model for option pricing

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Article ID: iaor20032165
Country: United States
Volume: 48
Issue: 8
Start Page Number: 1086
End Page Number: 1101
Publication Date: Aug 2002
Journal: Management Science
Authors:
Keywords: investment
Abstract:

Brownian motion and normal distribution have been widely used in the Black–Scholes option-pricing framework to model the return of assets. However, two puzzles emerge from many empirical investigations: the leptokurtic feature that the return distribution of assets may have a higher peak and two (asymmetric) heavier tails than those of the normal distribution, and an empirical phenomenon called ‘volatility smile’ in option markets. To incorporate both of them and to strike a balance between reality and tractability, this paper proposes, for the purposes of option pricing, a double exponential jump-diffusion model. In particular, the model is simple enough to produce analytical solutions for a variety of option-pricing problems, inlcuding call and put options, interest rate derivatives, and path-dependent options. Equilibrium analysis and a psychological interpretation of the model are also presented.

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