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Taking into account extreme events in European option pricing

Gaelle Le Fol, Julien Idier, Caroline Jardet (), Alain Monfort () and Fulvio Pegoraro
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Fulvio Pegoraro: Centre de recherche de la Banque de France - Banque de France

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Abstract: According to traditional option pricing models,1 fi nancial markets underestimate the impact of tail risk. In this article, we put forward a European option pricing model based on a set of assumptions that ensure, inter alia, that extreme events are better taken into account. Using simulations, we compare the option prices obtained from the standard Black and Scholes model with those resulting from our model. We show that the traditional model leads to an overvaluation of at-the-money options, which are the most traded options, while the less liquid in-the-money and out-of-the-money options are undervalued.

Keywords: Option pricing; mixture of Gaussian distributions; tail risk (search for similar items in EconPapers)
Date: 2008-10-01
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Published in Financial Stability Review, 2008, 12, pp.39-51

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