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Option pricing: a yet simpler approach

Author

Listed:
  • Jarno Talponen

    (University of Eastern Finland
    University of Helsinki)

  • Minna Turunen

    (University of Eastern Finland)

Abstract

We provide a lean, non-technical exposition on the pricing of path-dependent and European-style derivatives in the Cox–Ross–Rubinstein (CRR) pricing model. The main tool used in this paper for simplifying the reasoning is applying static hedging arguments. In applying the static hedging principle, we consider Arrow–Debreu securities and digital options, or backward random processes. In the last case, the CRR model is extended to an infinite state space which leads to an interesting new phenomenon not present in the classical CRR model. At the end, we discuss the paradox involving the drift parameter $$\mu $$ μ in the Black–Scholes–Merton model pricing. We provide sensitivity analysis and an approximation of the speed of convergence for the asymptotically vanishing effect of drift in prices.

Suggested Citation

  • Jarno Talponen & Minna Turunen, 2022. "Option pricing: a yet simpler approach," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 45(1), pages 57-81, June.
    • Handle: RePEc:spr:decfin:v:45:y:2022:i:1:d:10.1007_s10203-021-00338-7
    DOI: 10.1007/s10203-021-00338-7
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    References listed on IDEAS

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    More about this item

    Keywords

    Derivatives; Lattice model; CRR model; Backward process;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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