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Time-Changed Levy Processes and Option Pricing

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Author Info

  • Peter Carr

    (New York University)

  • Liuren Wu

    (Fordham University)

Abstract

As is well known, the classic Black­Scholes option pricing model assumes that returns follow Brownian motion. It is widely recognized that return processes differ from this benchmark in at least three important ways. First, asset prices jump, leading to non­normal return innovations. Second, return volatilities vary stochastically over time. Third, returns and their volatilities are correlated, often negatively for equities. We propose that time­changed Levy processes be used to simultaneously address these three facets of the underlying asset return process. We show that our framework encompasses almost all of the models proposed in the option pricing literature. Despite the generality of our approach, we show that it is straightforward to select and test a particular option pricing model through the use of characteristic function technology.

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File URL: http://128.118.178.162/eps/fin/papers/0207/0207011.pdf
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Bibliographic Info

Paper provided by EconWPA in its series Finance with number 0207011.

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Length: 42 pages
Date of creation: 30 Aug 2002
Date of revision:
Handle: RePEc:wpa:wuwpfi:0207011

Note: Type of Document - pdf; prepared on MikTex; to print on postscript; pages: 42 ; figures: none. produced via dvipdfm
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Web page: http://128.118.178.162

Related research

Keywords: random time change; Levy processes; characteristic functions; option pricing; exponen­tial martingales; measure change;

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References

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  1. Benninga, Simon & Björk, Tomas & Wiener, Zvi, 2002. "On the Use of Numeraires in Option pricing," Working Paper Series in Economics and Finance 484, Stockholm School of Economics.
  2. Markus Leippold & Liuren Wu, 2002. "Asset Pricing Under The Quadratic Class," Finance 0207015, EconWPA.
  3. Bates, David S., 2000. "Post-'87 crash fears in the S&P 500 futures option market," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 181-238.
  4. Geert Bekaert & Guojun Wu, 1997. "Asymmetric Volatility and Risk in Equity Markets," NBER Working Papers 6022, National Bureau of Economic Research, Inc.
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  13. Joshua Rosenberg & Robert F. Engle, 2000. "Empirical Pricing Kernels," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-014, New York University, Leonard N. Stern School of Business-.
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  17. Haugen, Robert A & Talmor, Eli & Torous, Walter N, 1991. " The Effect of Volatility Changes on the Level of Stock Prices and Subsequent Expected Returns," Journal of Finance, American Finance Association, vol. 46(3), pages 985-1007, July.
  18. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-86, March.
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