A Jump-Diffusion Model for Option Pricing

S. G. Kou
2002 Management science  
B rownian motion and normal distribution have been widely used in the Black-Scholes option-pricing framework to model the return of assets. However, two puzzles emerge from many empirical investigations: the leptokurtic feature that the return distribution of assets may have a higher peak and two (asymmetric) heavier tails than those of the normal distribution, and an empirical phenomenon called "volatility smile" in option markets. To incorporate both of them and to strike a balance between
more » ... lity and tractability, this paper proposes, for the purpose of option pricing, a double exponential jump-diffusion model. In particular, the model is simple enough to produce analytical solutions for a variety of option-pricing problems, including call and put options, interest rate derivatives, and pathdependent options. Equilibrium analysis and a psychological interpretation of the model are also presented.
doi:10.1287/mnsc.48.8.1086.166 fatcat:xx6mnjvjifeztgal7wcocpfyom