Foundations of Option Pricing

Peter Buchen ()
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Peter Buchen: University of Sydney

Chapter 22 in Handbook on Information Technology in Finance, 2008, pp 515-542 from Springer

Abstract: Abstract In this chapter we lay down the foundations of option and derivative security pricing in the classical Black-Scholes (BS) paradigm. The two key assumptions in this approach are the absence of arbitrage and the modelling of asset prices by geometrical Brownian motion (gBm). No arbitrage is the driving mechanism for much of modern finance and still plays a dominant role in models extended beyond the BS framework. It is generally recognised that gBm, which implies Gaussian logreturns of asset prices, while good for analysis is rather a poor description of reality. Financial data very often show stylised features in their log-return distributions that are highly non-Gaussian. These include, heavy-tails (leptokurtosis), skewness, stochastic volatility and long-range dependence. Unfortunately, no model of asset prices capturing all, or even some of these features, is widely accepted by either theorists or practitioners.

Keywords: Asset Price; Option Price; Stochastic Volatility; Call Option; Strike Price (search for similar items in EconPapers)
Date: 2008
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Persistent link: https://EconPapers.repec.org/RePEc:spr:ihichp:978-3-540-49487-4_22

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DOI: 10.1007/978-3-540-49487-4_22

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