IDEAS home Printed from https://ideas.repec.org/a/wsi/ijtafx/v02y1999i03ns0219024999000182.html
   My bibliography  Save this article

The Entropy Theory Of Stock Option Pricing

Author

Listed:
  • LES GULKO

    (287 Hamilton Avenue, #3C, Stamford, CT 06902, USA)

Abstract

An informationally efficient price keeps investors as a group in the state of maximum uncertainty about the next price change. The Entropy Pricing Theory (EPT) captures this intuition and suggests that, in informationally efficient markets, perfectly uncertain market beliefs must prevail. When the entropy functional is used to index the market uncertainty, then the entropy-maximizing market beliefs must prevail. The EPT resolves the ambiguity of asset valuation in incomplete markets, notably, the valuation of derivative securities. We use the EPT to derive a new stock option pricing model that is similar to Black–Scholes' with the lognormal distribution replaced by a gamma distribution. Unlike the Black–Scholes model, the gamma model does not restrict the dynamics of the stock price or the short-term interest rate. Option replication based on the gamma model accounts for random changes in the stock price, price volatility and interest rates.

Suggested Citation

  • Les Gulko, 1999. "The Entropy Theory Of Stock Option Pricing," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 2(03), pages 331-355.
    • Handle: RePEc:wsi:ijtafx:v:02:y:1999:i:03:n:s0219024999000182
    DOI: 10.1142/S0219024999000182
    as

    Download full text from publisher

    File URL: http://www.worldscientific.com/doi/abs/10.1142/S0219024999000182
    Download Restriction: Access to full text is restricted to subscribers
    File URL: https://libkey.io/10.1142/S0219024999000182?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Omid M. Ardakani, 2022. "Option pricing with maximum entropy densities: The inclusion of higher‐order moments," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 42(10), pages 1821-1836, October.
    2. Paul McCloud, 2020. "Expectation and Price in Incomplete Markets," Papers 2006.16703, arXiv.org.
    3. Minzhi Wu & Emili Tortosa-Ausina, 2020. "Bank Diversification and Focus in Disruptive Times: China, 2007–2018," Working Papers 2020/21, Economics Department, Universitat Jaume I, Castellón (Spain).
    4. Malhotra, Gifty & Srivastava, R. & Taneja, H.C., 2019. "Calibration of the risk-neutral density function by maximization of a two-parameter entropy," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 513(C), pages 45-54.
    5. Luckshay Batra & Harish Chander Taneja, 2022. "Comparison between Information Theoretic Measures to Assess Financial Markets," FinTech, MDPI, vol. 1(2), pages 1-18, May.
    6. Muhammad Sheraz & Imran Nasir, 2021. "Information-Theoretic Measures and Modeling Stock Market Volatility: A Comparative Approach," Risks, MDPI, vol. 9(5), pages 1-20, May.
    7. Sylvia Gottschalk, 2016. "Entropy and credit risk in highly correlated markets," Papers 1604.07042, arXiv.org.
    8. John A. Buzacott, 2016. "Capital allocation to alternatives with a multivariate ladder gamma return distribution," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 39(2), pages 235-258, November.
    9. Będowska-Sójka, Barbara & Kliber, Agata, 2021. "Information content of liquidity and volatility measures," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 563(C).
    10. Batra, Luckshay & Taneja, H.C., 2021. "Approximate-Analytical solution to the information measure’s based quanto option pricing model," Chaos, Solitons & Fractals, Elsevier, vol. 153(P1).
    11. Colin Beardsley & John R. O'Brien, 2005. "The Financial Services Reform Act 2001: Impact on Systemic risk in Australia," ICMA Centre Discussion Papers in Finance icma-dp2005-12, Henley Business School, University of Reading.
    12. Gottschalk, Sylvia, 2017. "Entropy measure of credit risk in highly correlated markets," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 478(C), pages 11-19.
    13. Kai Schindelhauer & Chen Zhou, 2018. "Value-at-Risk prediction using option-implied risk measures," DNB Working Papers 613, Netherlands Central Bank, Research Department.
    14. Grilli, Luca & Santoro, Domenico, 2020. "Boltzmann Entropy in Cryptocurrencies: A Statistical Ensemble Based Approach," MPRA Paper 99591, University Library of Munich, Germany.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:wsi:ijtafx:v:02:y:1999:i:03:n:s0219024999000182. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no bibliographic references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Tai Tone Lim (email available below). General contact details of provider: http://www.worldscinet.com/ijtaf/ijtaf.shtml .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.