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A No-Arbitrage Martingale Analysis for Jump-Diffusion Valuation

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  • Chang, Carolyn W
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    This study presents a jump-diffusion valuation framework using the no-arbitrage martingale approach. Equilibrium conditions needed to support a jump-diffusion pricing standard process are derived. The results are a generalized jump-diffusion security market line and its corresponding equilibrium valuation relation that prices both jump and diffusion risk. To value options, a fundamental formula is derived that includes existing jump-diffusion option valuation formulas as special cases. I find Merton's (1976) assumption of diversifiable jump risk to be consistent with no-arbitrage only when the aggregate consumption flow does not jump. Simulation shows that Merton's formula undervalues/overvalues options on hedging/cyclical assets. When the jump arrival frequency is larger, the mispricing is larger/smaller for in-the-money/out-of-the-money options.

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

    Volume (Year): 18 (1995)
    Issue (Month): 3 (Fall)
    Pages: 351-381

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    Handle: RePEc:bla:jfnres:v:18:y:1995:i:3:p:351-81
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