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Call Option Valuation for Discrete Normal Mixtures

Listed author(s):
  • Ritchey, Robert J
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    In this study a mixture call option pricing model is derived to examine the impact of non-normal underlying returns densities. Observed fat-tailed and skewed distributions are assumed to be the results of independent Gaussian processes with nonstationary parameters, modeled by discrete k-component independent normal mixtures. The mixture model provides an exact solution with intuitive appeal using weighted sums of Black-Scholes (B-S) solutions. Simulating returns densities representative of equity securities, significant mispricing by B-S is found in low-priced at- and out-of-the-money near-term options. the lower the variance and the higher the leptokurtosis and positive skewness of the underlying returns, the more pronounced is this mispricing. Values of in-the-money options and options with several weeks or more to expiration are closely approximated by B-S.

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    Article provided by Southern Finance Association & Southwestern Finance Association in its journal Journal of Financial Research.

    Volume (Year): 13 (1990)
    Issue (Month): 4 (Winter)
    Pages: 285-296

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    Handle: RePEc:bla:jfnres:v:13:y:1990:i:4:p:285-96
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