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Options Pricing with Arithmetic Brownian Motion and its Implication for Risk-Neutral Valuation

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  • Qiang Liu

    (School of Management, University of Electronic Science & Technology of China)

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    Abstract

    Risk-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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    File URL: http://128.118.178.162/eps/fin/papers/0512/0512001.pdf
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    Bibliographic Info

    Paper provided by EconWPA in its series Finance with number 0512001.

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    Length: 5 pages
    Date of creation: 01 Dec 2005
    Date of revision:
    Handle: RePEc:wpa:wuwpfi:0512001

    Note: Type of Document - pdf; pages: 5
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    Web page: http://128.118.178.162

    Related research

    Keywords: risk-neutral valuation; arithmetic Brownian motion; options price formula;

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