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An empirical model of volatility of returns and option pricing

Author

Listed:
  • J.L. McCauley
  • G.h. Gunaratne

Abstract

This paper reports several entirely new results on financial market dynamics and option pricing We observe that empirical distributions of returns are much better approximated by an exponential distribution than by a Gaussian. This exponential distribution of asset prices can be used to develop a new pricing model for options (in closed algebraic form) that is shown to provide valuations that agree very well with those used by traders. We show how the Fokker-Planck formulation of fluctuations can be used with a local volatility (diffusion coeffficient) to generate an exponential distribution for asset returns, and also how fat tails for extreme returns are generated dynamically by a simple generalization of our new volatility model. Nonuniqueness in deducing dynamics from empirical data is discussed and is shown to have no practical effect over time scales much less than one hundred years. We derive an option pricing pde and explain why it‘s superfluous, because all information required to price options in agreement with the delta-hedge is already included in the Green function of the Fokker-Planck equation for a special choice of parameters. Finally, we also show how to calculate put and call prices for a stretched exponential returns density.
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Suggested Citation

  • J.L. McCauley & G.h. Gunaratne, 2002. "An empirical model of volatility of returns and option pricing," Computing in Economics and Finance 2002 186, Society for Computational Economics.
    • Handle: RePEc:sce:scecf2:186
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    Cited by:

    1. Giacomo Bormetti & Sofia Cazzaniga, 2011. "Multiplicative noise, fast convolution, and pricing," Papers 1107.1451, arXiv.org.
    2. Shi, Leilei, 2006. "Does security transaction volume–price behavior resemble a probability wave?," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 366(C), pages 419-436.
    3. Decamps, Marc & De Schepper, Ann & Goovaerts, Marc, 2004. "Applications of δ-function perturbation to the pricing of derivative securities," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 342(3), pages 677-692.
    4. McCauley, Joseph l., 2004. "Thermodynamic analogies in economics and finance: instability of markets," MPRA Paper 2159, University Library of Munich, Germany.
    5. McCauley, Joseph L., 2003. "Scaling, correlations, and cascades in finance and turbulence," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 329(1), pages 213-221.
    6. McCauley, Joseph L., 2003. "Thermodynamic analogies in economics and finance: instability of markets," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 329(1), pages 199-212.
    7. Jinkyu Kim & Gunn Kim & Sungbae An & Young-Kyun Kwon & Sungroh Yoon, 2013. "Entropy-Based Analysis and Bioinformatics-Inspired Integration of Global Economic Information Transfer," PLOS ONE, Public Library of Science, vol. 8(1), pages 1-10, January.
    8. Bucsa, G. & Jovanovic, F. & Schinckus, C., 2011. "A unified model for price return distributions used in econophysics," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 390(20), pages 3435-3443.
    9. Seemann, Lars & Hua, Jia-Chen & McCauley, Joseph L. & Gunaratne, Gemunu H., 2012. "Ensemble vs. time averages in financial time series analysis," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 391(23), pages 6024-6032.
    10. Giacomo Bormetti & Sofia Cazzaniga, 2014. "Multiplicative noise, fast convolution and pricing," Quantitative Finance, Taylor & Francis Journals, vol. 14(3), pages 481-494, March.
    11. Ramos, Antônio M.T. & Carvalho, J.A. & Vasconcelos, G.L., 2016. "Exponential model for option prices: Application to the Brazilian market," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 445(C), pages 161-168.
    12. de Mattos Neto, Paulo S.G. & Silva, David A. & Ferreira, Tiago A.E. & Cavalcanti, George D.C., 2011. "Market volatility modeling for short time window," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 390(20), pages 3444-3453.
    13. Sosa-Correa, William O. & Ramos, Antônio M.T. & Vasconcelos, Giovani L., 2018. "Investigation of non-Gaussian effects in the Brazilian option market," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 496(C), pages 525-539.
    14. Zheng, Zhiyong & Lu, Yunfan & Zhang, Junhuan, 2022. "Multiscale complexity fluctuation behaviours of stochastic interacting cryptocurrency price model," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 593(C).
    15. Shu-Heng Chen & Sai-Ping Li, 2011. "Econophysics: Bridges over a Turbulent Current," Papers 1107.5373, arXiv.org.
    16. Victor M. Yakovenko & J. Barkley Rosser, 2009. "Colloquium: Statistical mechanics of money, wealth, and income," Papers 0905.1518, arXiv.org, revised Dec 2009.
    17. Marcin Wk{a}torek & Stanis{l}aw Dro.zd.z & Jaros{l}aw Kwapie'n & Ludovico Minati & Pawe{l} O'swik{e}cimka & Marek Stanuszek, 2020. "Multiscale characteristics of the emerging global cryptocurrency market," Papers 2010.15403, arXiv.org, revised Mar 2021.
    18. Bassler, Kevin E. & McCauley, Joseph L. & Gunaratne, Gemunu H., 2006. "Nonstationary increments, scaling distributions, and variable diffusion processes in financial markets," MPRA Paper 2126, University Library of Munich, Germany.
    19. Jovanovic, Franck & Schinckus, Christophe, 2017. "Econophysics and Financial Economics: An Emerging Dialogue," OUP Catalogue, Oxford University Press, number 9780190205034.
    20. Joesph L. McCauley, 2002. "Self-Financing, Replicating Hedging Strategies, an incomplete thermodynamic analogy," Papers cond-mat/0203304, arXiv.org.

    More about this item

    Keywords

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    JEL classification:

    • G0 - Financial Economics - - General
    • D5 - Microeconomics - - General Equilibrium and Disequilibrium

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