Non-monotonic pricing kernel and an extended class of mixture of distributions for option pricing

Luiz Vitiello and Ser-Huang Poon

Review of Derivatives Research, 2014, vol. 17, issue 2, 259 pages

Abstract: We derive closed form European option pricing formulae under the general equilibrium framework for underlying assets that have an $$N$$ N -mixture of transformed normal distributions. The component distributions need not belong to the same class but must all be transformed normal. An important implication of our results is that the mixture of distributions is consistent with a “what appears to be abnormal” non-monotonic (asset specific) pricing kernel for the S&P 500 and that the representative agent has a “logical” monotonic decreasing marginal utility. We show that a mixture of two lognormal distributions is sufficient to produce this result and also implied volatility smiles of a wide variety of shapes. Copyright Springer Science+Business Media New York 2014

Keywords: Mixture of distributions; Transformed-normal distribution; Risk neutral valuation relationship; Option pricing; G13 (search for similar items in EconPapers)
Date: 2014
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DOI: 10.1007/s11147-013-9093-5

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