Abstract
Applying the Cherny-Shiryaev-Yor invariance principle, we introduce a generalized Jarrow-Rudd (GJR) option pricing model with uncertainty driven by a skew random walk. The GJR pricing tree exhibits skewness and kurtosis in both the natural and risk-neutral world. We construct implied surfaces for the parameters determining the GJR tree. Motivated by Merton's pricing tree incorporating transaction costs, we extend the GJR pricing model to include a hedging cost. We demonstrate ways to fit the GJR pricing model to a market driver that influences the price dynamics of the underlying asset. We supplement our findings with numerical examples.
Original language | English |
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Article number | 104345 |
Journal | Journal of Economic Dynamics and Control |
Volume | 137 |
DOIs | |
State | Published - Apr 2022 |
Keywords
- Cherny-Shiryaev-Yor invariance principle
- Hedging transaction cost
- Jarrow-Rudd binomial option pricing
- Skew random walk