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Asset Pricing with Random Volatility

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  • Xin Liu

Abstract

This paper proposes to model asset price dynamics with a mixture of diffusion processes where the instantaneous volatility of the underlying diffusion process contains a random vector. The marginal probability distributions of the proposed process can match exactly the risk-neutral distributions implied by both spot vanilla options and forward start options. We can also derive the explicit pricing formula for derivatives that have a closed-form solution under Generalized Geometric Brownian Motion.

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  • Xin Liu, 2016. "Asset Pricing with Random Volatility," Papers 1610.01450, arXiv.org, revised Sep 2018.
    • Handle: RePEc:arx:papers:1610.01450
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    References listed on IDEAS

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    1. Damiano Brigo & Fabio Mercurio, 2002. "Lognormal-Mixture Dynamics And Calibration To Market Volatility Smiles," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 5(04), pages 427-446.
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    6. Alexander, Carol, 2004. "Normal mixture diffusion with uncertain volatility: Modelling short- and long-term smile effects," Journal of Banking & Finance, Elsevier, vol. 28(12), pages 2957-2980, December.
    7. Robert J. Ritchey, 1990. "Call Option Valuation For Discrete Normal Mixtures," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 13(4), pages 285-296, December.
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