Non-monotonic pricing kernel and an extended class of mixture of distributions for option pricing

Luiz Vitiello, Ser Huang Poon

Research output: Contribution to journalArticlepeer-review

Abstract

We derive closed form European option pricing formulae under the general equilibrium framework for underlying assets that have an {Mathematical expression}-mixture of transformed normal distributions. The component distributions need not belong to the same class but must all be transformed normal. An important implication of our results is that the mixture of distributions is consistent with a "what appears to be abnormal" non-monotonic (asset specific) pricing kernel for the S&P 500 and that the representative agent has a "logical" monotonic decreasing marginal utility. We show that a mixture of two lognormal distributions is sufficient to produce this result and also implied volatility smiles of a wide variety of shapes. © 2013 Springer Science+Business Media New York.
Original languageEnglish
Pages (from-to)241-259
Number of pages18
JournalReview of Derivatives Research
Volume17
Issue number2
Early online date8 Nov 2013
DOIs
Publication statusPublished - 1 Jul 2014

Keywords

  • Mixture of distributions
  • Option pricing
  • Risk neutral valuation relationship
  • Transformed-normal distribution

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