Chapter 7 Beyond Black-Scholes.ppt

Chapter 7: Beyond Black-Scholes Black-Scholes Model for vanilla options Implied volatility and volatility smile Implied volatility Volatility smile Continued Improved models Local volatility model Stochastic volatility model Jump diffusion model Others: discrete hedging, transaction cost Local volatility model A special case: Identification of How to use the local volatility model Calibration of the model: Identify the volatility function from the market prices of vanilla options Price non-traded contracts by using the model Stochastic volatility model Pricing model Continued The Market Price of Risk Risk neutral processes Derivatives on a single underlying variable Pricing equation Two Named Models Hull White Heston Example 1: Hull-White model Example 2: Heston Model Jump-diffusion model Poisson process Jump-diffusion Process Hedging Ito Lemma Merton’s Model 1976 Jump risks are diversified Summary: purpose Understand the market better Price options at the OCT market Black-Scholes world Beyond the Black-Scholes World Local volatility model Stochastic volatility model Jump diffusion model Parameters Local volatility model: ? ? S,t Stochastic volatility model: Hull-White model 3 parameters Heston model 2 parameters Jump diffusion model ?, J * *