 The Pricing of Derivatives on Assets with Quadratic VolatilityChristian Zühlsdorff No 5/2002, Bonn Econ Discussion Papers from University of Bonn, Bonn Graduate School of Economics (BGSE) Abstract: The basic model of financial economics is the Samuelson model of geometric Brownian motion because of the celebrated Black-Scholes formula for pricing the call option. The asset's volatility is a linear function of the asset value and the model garantees positive asset prices. In this paper it is shown that the pricing partial differential equation can be solved for level-dependent volatility which is a quadratic polynomial. If zero is attainable, both absorption and negative asset values are possible. Explicit formulae are derived for the call option: a generalization of the Black-Scholes formula for an asset whose volatiliy is affine, the formula for the Bachelier model with constant volatility, and new formulae in the case of quadratic volatility. The implied Black-Scholes volatilities of the Bachelier and the affine model are frowns, the quadratic specifications imply smiles. Keywords: strong solutions; stochastic differential equation; option pricing; quadratic volatility; implied volatility; smiles; frowns (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:zbw:bonedp:52002 Access Statistics for this paper More papers in Bonn Econ Discussion Papers from University of Bonn, Bonn Graduate School of Economics (BGSE) Contact information at EDIRC. |
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