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Option Pricing with Normal Mixture Returns: Modelling Excess Kurtosis and Uncertanity in Volatility

Carol Alexander () and Sujit Narayanan ()
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Sujit Narayanan: ICMA Centre, University of Reading

ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading

Abstract: his paper addresses the problem of uncertainty in volatility, and how this affects option prices. The volatility uncertainty adjustment to Black-Scholes option prices is quantified in this paper using a normal mixture model for the distribution of underlying returns, or equivalently, assuming a mixture of lognormal densities for the density of the asset price. The use of a lognormal mixture price process for pricing options is not new (Ritchey, 1990) but the local volatility that should be used in the lognormal mixture price process has only recently been established (Brigo and Mercurio, 2000a, 2001).Â

Keywords: Option Pricing with Normal Mixture Density Excess Kurtosis skewness; volatility uncertainty; exchange rates; equity indices (search for similar items in EconPapers)
Pages: 34 pages
Date: 2001-11, Revised 2001-12
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