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Taking into account extreme events in European option pricing

Idier, Julien; Jardet, Caroline; Le Fol, Gaëlle; Monfort, Alain; Pegoraro, Fulvio (2008), Taking into account extreme events in European option pricing, Financial Stability Review, 12, p. 39-51

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Type
Article accepté pour publication ou publié
Date
2008
Journal name
Financial Stability Review
Number
12
Publisher
Banque de France
Pages
39-51
Metadata
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Author(s)
Idier, Julien
Jardet, Caroline
Le Fol, Gaëlle
Monfort, Alain
Pegoraro, Fulvio
Abstract (EN)
According to traditional option pricing models, financial markets underestimate the impact of tail risk. In this article, we put forward a European option pricing model based on a set of assumptions that ensure, inter alia, that extreme events are better taken into account. Using simulations, we compare the option prices obtained from the standard Black and Scholes model with those resulting from our model. We show that the traditional model leads to an overvaluation of at-the-money options, which are the most traded options, while the less liquid in-the-money and out-of-the-money options are undervalued.
Subjects / Keywords
tail risk; option pricing models
JEL
G19 - Other