Lognormal Mixture Model for Option Pricing with Applications to Exotic Options

option pricing;mixture;lognormal;exotic options;volatility smile;Actuarial Science

Fang, Mingyu

University of Waterloo

关键词: option pricing;    mixture;    lognormal;    exotic options;    volatility smile;    Actuarial Science;   

Others  :  https://uwspace.uwaterloo.ca/bitstream/10012/6869/1/Fang_Mingyu.pdf

瑞士|英语

来源: UWSPACE Waterloo Institutional Repository

【 摘 要 】

The Black-Scholes option pricing model has several well recognized deficiencies, one ofwhich is its assumption of a constant and time-homogeneous stock return volatility term. The implied volatility smile has been studied by subsequent researchers and various models have been developed in an attempt to reproduce this phenomenon from within the models. However, few of these models yield closed-form pricing formulas that are easy to implement in practice. In this thesis, we study a Mixture Lognormal model (MLN) for European option pricing, which assumes that future stock prices are conditionally described by a mixture of lognormal distributions. The ability of mixture models in generating volatilitysmiles as well as delivering pricing improvement over the traditional Black-Scholes framework have been much researched under multi-component mixtures for many derivatives and high-volatility individual stock options. In this thesis, we investigate the performance of the model under the simplest two-component mixture in a market characterized by relative tranquillity and over a relatively stable period for broad-based index options. Acareful interpretation is given to the model and the results obtained in the thesis. Thisdi erentiates our study from many previous studies on this subject. Throughout the thesis, we establish the unique advantage of the MLN model, which is having closed-form option pricing formulas equal to the weighted mixture of Black-Scholesoption prices. We also propose a robust calibration methodology to fit the model to market data. Extreme market states, in particular the so-called crash-o-phobia effect, are shown to be well captured by the calibrated model, albeit small pricing improvements are made over a relatively stable period of index option market. As a major contribution of this thesis, we extend the MLN model to price exotic options including binary, Asian, and barrier options.Closed-form formulas are derived for binary and continuously monitored barrier optionsand simulation-based pricing techniques are proposed for Asian and discretely monitoredbarrier options. Lastly, comparative results are analysed for various strike-maturity combinations, which provides insights into the formulation of hedging and risk management strategies.