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Option Pricing Based on Alternative Jump Size Distributions |
Jian Chen1(),Chenghu Ma2() |
1. School of Economics, Xiamen University, Xiamen 361005, China 2. School of Management, Fudan University, Shanghai 200433, China |
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Abstract It is well known that volatility smirks and heavy-tailed asset return distributions are two violations of the Black-Scholes model. This paper investigates the role of jump size distribution played in explaining these two abnormalities. We consider a jump-diffusion model with Laplace jump size distribution, in comparison to the conventional normal distribution. In addition, our analysis is built upon a pure exchange economy, in which the representative agent’s risk preference shows a fanning characteristic. We find that, when a fanning effect is present, Laplace model produces a more remarkable leptokurtic pattern of the risk-neutral distribution implied by options, as well as generating more pronounced volatility smirks than the normal model.
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Keywords
general equilibrium
recursive utility
option pricing
Laplace distribution
volatility smirk
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Issue Date: 23 September 2016
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