Options Pricing with Arithmetic Brownian Motion and its Implication for Risk-Neutral Valuation
AbstractRisk-neutral valuation is used widely in derivatives pricing. It is shown in this paper, however, that the naïve approach of simply setting the growth rate of the underlying security to risk-free interest rate, which happens to work for a geometric Brownian motion (GBM) process, fails to work when the underlying price follows the arithmetic Brownian motion (ABM). Therefore, the formal approach using a martingale measure should be used instead when the underlying process is not a GBM.
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Bibliographic InfoPaper provided by EconWPA in its series Finance with number 0512001.
Length: 5 pages
Date of creation: 01 Dec 2005
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Note: Type of Document - pdf; pages: 5
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risk-neutral valuation; arithmetic Brownian motion; options price formula;
Find related papers by JEL classification:
- G - Financial Economics
This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-12-09 (All new papers)
- NEP-FMK-2005-12-09 (Financial Markets)
- NEP-SEA-2005-12-09 (South East Asia)
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