The Impact of Return Nonnormality on Exchange Options

Minqiang Li

MPRA Paper from University Library of Munich, Germany

Abstract: The Margrabe formula is used extensively by theorists and practitioners not only on exchange options, but also on executive compensation schemes, real options, weather and commodity derivatives, etc. However, the crucial assumption of a bivariate normal distribution is not fully satisfied in almost all applications. The impact of nonnormality on exchange options is studied by using a bivariate Gram-Charlier approximation. For near-the-money exchange options, skewness and coskewness induce price corrections which are linear in moneyness, while kurtosis and cokurtosis induce quadratic price corrections. The nonnormality helps to explain the implied correlation smile observed in practice.

JEL-codes: C00 G13 (search for similar items in EconPapers)
Date: 2007
New Economics Papers: this item is included in nep-ifn
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