Market complete option valuation using a Jarrow-Rudd pricing tree with skewness and kurtosis

Yuan Hu, W. Brent Lindquist, Svetlozar T. Rachev, Abootaleb Shirvani and Frank J. Fabozzi

Journal of Economic Dynamics and Control, 2022, vol. 137, issue C

Abstract: Applying the Cherny-Shiryaev-Yor invariance principle, we introduce a generalized Jarrow-Rudd (GJR) option pricing model with uncertainty driven by a skew random walk. The GJR pricing tree exhibits skewness and kurtosis in both the natural and risk-neutral world. We construct implied surfaces for the parameters determining the GJR tree. Motivated by Merton’s pricing tree incorporating transaction costs, we extend the GJR pricing model to include a hedging cost. We demonstrate ways to fit the GJR pricing model to a market driver that influences the price dynamics of the underlying asset. We supplement our findings with numerical examples.

Keywords: Jarrow-Rudd binomial option pricing; Skew random walk; Cherny-Shiryaev-Yor invariance principle; Hedging transaction cost (search for similar items in EconPapers)
JEL-codes: G13 G17 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:137:y:2022:i:c:s0165188922000501

DOI: 10.1016/j.jedc.2022.104345

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