The Finite Moment Log Stable Process and Option Pricing

Peter Carr, Liuren Wu

Research output: Contribution to journalArticlepeer-review

Abstract

We document a surprising pattern in S&P 500 option prices. When implied volatilities are graphed against a standard measure of moneyness, the implied volatility smirk does not flatten out as maturity increases up to the observable horizon of two years. This behavior contrasts sharply with the implications of many pricing models and with the asymptotic behavior implied by the central limit theorem (CLT). We develop a parsimonious model which deliberately violates the CLT assumptions and thus captures the observed behavior of the volatility smirk over the maturity horizon. Calibration exercises demonstrate its superior performance against several widely used alternatives.

Original languageEnglish (US)
Pages (from-to)753-778
Number of pages26
JournalJournal of Finance
Volume58
Issue number2
DOIs
StatePublished - Apr 2003

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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