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A New Tempered Stable Distribution and Its Application to Finance

In: Risk Assessment

Author

Listed:
  • Young Shin Kim

    (University of Karlsruhe)

  • Svetlozar T. Rachev

    (University of Karlsruhe)

  • Michele Leonardo Bianchi

    (University of Bergamo)

  • Frank J. Fabozzi

    (Yale School of Management)

Abstract

In this paper, we will discuss a parametric approach to risk-neutral density extraction from option prices based on the knowledge of the estimated historical density. A flexible distribution is needed in order to find an equivalent change of measure and, at the same time, take into account the historical estimates. To this end, we introduce a new tempered stable distribution that we refer to as the KR distribution. Some properties of this distribution will be discussed in this paper, along with the advantages in applying it to financial modeling. Since the KR distribution is infinitely divisible, a Lélvy process can be induced from it. Furthermore, we can develop an exponential Lévy model, called the exponential KR model, and prove that it is an extension of the Carr, Geman, Madan, and Yor (CGMY) model. The risk-neutral process is fitted by matching model prices to market prices of options using nonlinear least squares. The easy form of the characteristic function of the KR distribution allows one to obtain a suitable solution to the calibration problem. To demonstrate the advantages of the exponential KR model, we present the results of the parameter estimation for the S&P 500 Index and option prices.

Suggested Citation

  • Young Shin Kim & Svetlozar T. Rachev & Michele Leonardo Bianchi & Frank J. Fabozzi, 2009. "A New Tempered Stable Distribution and Its Application to Finance," Contributions to Economics, in: Georg Bol & Svetlozar T. Rachev & Reinhold Würth (ed.), Risk Assessment, pages 77-109, Springer.
    • Handle: RePEc:spr:conchp:978-3-7908-2050-8_5
    DOI: 10.1007/978-3-7908-2050-8_5
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    Citations

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    Cited by:

    1. Jorge González Cázares & Aleksandar Mijatović, 2022. "Simulation of the drawdown and its duration in Lévy models via stick-breaking Gaussian approximation," Finance and Stochastics, Springer, vol. 26(4), pages 671-732, October.
    2. Sung Ik Kim, 2022. "ARMA–GARCH model with fractional generalized hyperbolic innovations," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 8(1), pages 1-25, December.
    3. Jorge Gonz'alez C'azares & Aleksandar Mijatovi'c, 2020. "Simulation of the drawdown and its duration in L\'{e}vy models via stick-breaking Gaussian approximation," Papers 2011.06618, arXiv.org, revised Mar 2021.

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