A generalized European option pricing model with risk management

Chengxiao Feng, Jie Tan, Zhenyu Jiang and Shuang Chen

Physica A: Statistical Mechanics and its Applications, 2020, vol. 545, issue C

Abstract: Risk control systems in financial markets with numerous innovative financial products are characterized by infrequent and significant fluctuations (e.g., financial crises and minor disturbances occurring anytime and anywhere). Given that the traditional Black–Scholes (BS) model is difficult to adapt to ever-changing financial markets, to better describe real financial markets, this paper presents a generalized European option-pricing model with stochastic volatility and stochastic interest rates and pure jumps under Levy processes, which are stochastic processes with both stationary and independent increments. We use the Levy–Ito formula and measurement tools to transform logarithmic stock prices into conditions under risk neutral measures, and the characteristic functions of logarithmic stock prices are obtained using the decomposed characteristic function form. We in turn obtain a characteristic function solution based on the Fourier and inverse Fourier transform. Finally, we conduct a Monte Carlo (MC) simulation which highlight the adaptability, accuracy and efficiency of the FFT algorithm. The proposed model is superior from an economic and mathematics perspective, as it not only inherits advantages of the BS model but also better depicts the leptokurtosis and jump phenomenon in option markets.

Keywords: Finance; Option pricing; Risk management; Levy processes (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0378437119321132
Full text for ScienceDirect subscribers only. Journal offers the option of making the article available online on Science direct for a fee of $3,000

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:phsmap:v:545:y:2020:i:c:s0378437119321132

DOI: 10.1016/j.physa.2019.123797

Access Statistics for this article

Physica A: Statistical Mechanics and its Applications is currently edited by K. A. Dawson, J. O. Indekeu, H.E. Stanley and C. Tsallis

More articles in Physica A: Statistical Mechanics and its Applications from Elsevier
Bibliographic data for series maintained by Catherine Liu ().