Robust option replication for a Black-Scholes model extended with nondeterministic trends. (1999)

• Record Type: Journal Article
• Authors: Schoenmakers, John G. M.; Kloeden, Peter E.
• Is Part Of: Journal of applied mathematics and stochastic analysis. Volume 12:Number 2(1999)
• Page Start: 113
• Page End: 120
• Publication Date: 1999
• Subjects: Black and Scholes option price theory -- long-range dependence -- stochastic analysis of square zero variation processes -- portfolios -- arbitrage; Mathematical models -- Periodicals; Computer simulation -- Periodicals; Computer science -- Mathematics -- Periodicals; Computer science -- Mathematics; Computer simulation; Mathematical models; Applied Mathematics; Periodicals; Electronic journals; 519.22
• DOI: 10.1155/S104895339900012X
• Languages: English
• ISSNs: 1048-9533

Abstract

Abstract : Statistical analysis on various stocks reveals long range dependence behavior of the stock prices that is not consistent with the classical Black and Scholes model. This memory or nondeterministic trend behavior is often seen as a reflection of market sentiments and causes that the historical volatility estimator becomes unreliable in practice. We propose an extension of the Black and Scholes model by adding a term to the original Wiener term involving a smoother process which accounts for these effects. The problem of arbitrage will be discussed. Using a generalized stochastic integration theory [8], we show that it is possible to construct a self financing replicating portfolio for a European option without any further knowledge of the extension and that, as a consequence, the classical concept of volatility needs to be re-interpreted.