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A Forward Looking, Singular Perturbation Approach To Pricing Options Under Market Uncertainty And Trading Noise

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  • JORGE R. SOBEHART

    (Citigroup Risk Architecture, 153 E 53rd St., NY 10022, USA)

Abstract

In this article we examine the pricing of options when trading noise and uncertainty in the options markets invalidates the assumption that the price of the option depends solely on the price of the underlying security (or any set of underlying state variables). We show that the introduction of trading noise in the options market affects the call-put parity relationship, and can also contribute to generate implied volatility skews.

Suggested Citation

  • Jorge R. Sobehart, 2005. "A Forward Looking, Singular Perturbation Approach To Pricing Options Under Market Uncertainty And Trading Noise," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 8(05), pages 635-658.
    • Handle: RePEc:wsi:ijtafx:v:08:y:2005:i:05:n:s0219024905003165
    DOI: 10.1142/S0219024905003165
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    References listed on IDEAS

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    1. Adrian Dragulescu & Victor Yakovenko, 2002. "Probability distribution of returns in the Heston model with stochastic volatility," Quantitative Finance, Taylor & Francis Journals, vol. 2(6), pages 443-453.
    2. Allan M. Malz, 1997. "Option-implied probability distributions and currency excess returns," Staff Reports 32, Federal Reserve Bank of New York.
    3. Jean-Philippe Bouchaud & Marc Potters, 1998. "Back to basics: historical option pricing revisited," Science & Finance (CFM) working paper archive 500036, Science & Finance, Capital Fund Management.
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