Pricing of Index Options Under a Minimal Market Model with Lognormal Scaling
This paper describes a two-factor model for a diversified market index using the growth optimal portfolio with a stochastic and possibly correlated intrinsic time scale. The index is modeled using a time transformed squared Bessel process of dimension four with a lognormal scaling factor for the time transformation. A consistent pricing and hedging framework is established by using the benchmark approach. here the numeraire is taken to be the growth optimal portfolio. Benchmarked traded prices appear as conditional expectations of future benchmarked prices under the real world probability measure. The proposed minimal market model with lognormal scaling produces the type of implied volatility term structures for European call nd put options typically observed in real markets. In addition, the prices of binary options and their deviations from corresponding Black-Scholes prices are examined.
|Date of creation:||01 Jun 2003|
|Date of revision:|
|Publication status:||Published as: Heath, D. and Platen, E., 2003, "Pricing of Index Options Under a Minimal Market Model with Lognormal Scaling", Quantitative Finance, 3(6), 442-450.|
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