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The Impact of Return Nonnormality on Exchange Options

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  • Li, Minqiang

Abstract

The Margrabe formula is used extensively by theorists and practitioners not only on exchange options, but also on executive compensation schemes, real options, weather and commodity derivatives, etc. However, the crucial assumption of a bivariate normal distribution is not fully satisfied in almost all applications. The impact of nonnormality on exchange options is studied by using a bivariate Gram-Charlier approximation. For near-the-money exchange options, skewness and coskewness induce price corrections which are linear in moneyness, while kurtosis and cokurtosis induce quadratic price corrections. The nonnormality helps to explain the implied correlation smile observed in practice.

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File URL: http://mpra.ub.uni-muenchen.de/7020/
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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 7020.

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Date of creation: 2007
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Handle: RePEc:pra:mprapa:7020

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Cited by:
  1. Li, Minqiang & Deng, Shijie & Zhou, Jieyun, 2008. "Multi-asset Spread Option Pricing and Hedging," MPRA Paper 8259, University Library of Munich, Germany.

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