Electronic copy available at: http://ssrn.

com/abstract=2210359

0


A General Closed Form Option Pricing Formula




Ciprian NECULA
1,2
Gabriel DRIMUS
1
Walter FARKAS
1,3

1
Department of Banking and Finance, University of Zurich, Plattenstrasse 14, CH-8032, Zurich, Switzerland
Email: ciprian.necula@bf.uzh.ch, gabriel.drimus@bf.uzh.ch, walter.farkas@bf.uzh.ch.

2
Department of Money and Banking, DOFIN, Bucharest University of Economic Studies, Bucharest, Romania
3
Department of Mathematics, ETH Zurich, Raemistrasse 101, CH-8092 Zurich, Switzerland


First version: January 7, 2013
This version: January 25, 2013

Abstract
A new method to retrieve the risk-neutral probability measure from observed option prices is
developed and a closed-form pricing formula for European options is obtained by employing
a modified Gram-Charlier series expansion, known as the Gauss-Hermite expansion. This
new option pricing formula is an alternative to the inverse Fourier transform methodology
and can be employed in general models with probability distribution function or
characteristic function known in closed form. We calibrate the model to both simulated and
market option prices and find that the resulting implied volatility curve provides a good
approximation for a wide range of strikes.


Keywords: European options, Gauss-Hermite series expansion, calibration.

JEL Classification: C63, G13

Acknowledgements: This work was supported by a SCIEX-NMS Fellowship, Project Code
11.159.

Electronic copy available at: http://ssrn.com/abstract=2210359

1

1. Introduction
The risk-neutral valuation framework is one of the pillars of modern finance theory.
Under this framework, the risk-neutral probability measure is an essential ingredient for asset
valuation, since the value of a financial derivative is given by the expected value under the
risk-neutral measure of the future payoffs generated by the derivative, discounted at the
riskless interest rate. This approach was pioneered in the context of European option pricing
by Black and Scholes (1973) and Merton (1973) who postulated a Gaussian risk-neutral
measure and obtained the celebrated Black-Scholes-Merton (BSM) formula. The stylized fact
of volatility smiles has encouraged the development of various extensions that account for the
fact that the risk-neutral density is negatively skewed and leptokurtic, such as stochastic
volatility models (Heston, 1993), jump-diffusion models (Merton, 1976; Kou, 2002), models
based on the Generalized Hyperbolic process or other pure-jumps Levy processes (Bibby and
Sorensen, 1997).
It is nonetheless appealing to obtain the risk-neutral density from option prices data by
using non-parametric methods (Ait-Sahalia and Lo, 1998; Ait-Sahalia and Duarte, 2003) or
using an expansion around a density which is easy to compute, such as the normal or the log-
normal. Jarrow and Rudd (1982) pioneered the density expansion approach to option pricing
using an Edgeworth series expansion of the terminal underlying asset price risk-neutral
density around the log-normal density. Corrado and Su (1996, 1997) adopted the Jarrow
Rudd framework and derived an option pricing formula using a GramCharlier type A series
expansion of the underlying asset log-return risk-neutral density around the Gaussian density.
The pioneering papers of Jarrow and Rudd (1982) and Corrado and Su (1996) focused
on option pricing formulae based on a Gram-Charlier type A expansion, generated a seminal
branch of option pricing research. An overview on the Gram-Charlier density expansion
approach to option valuation is provided by Jurczenko, Maillet, and Negrea (2002). Brown
and Robinson (2002) corrected a typographic error in the initial Corrado and Su (1996)
formula and point out that call-put parity is no longer verified when the risk-neutral log-return
density function is approximated by a GramCharlier Type A series expansion, due to the
lack of the martingale restriction (Longstaff, 1995). Jurczenko, Maillet, and Negrea (2004)
slightly modified the original formula to provide consistency with a martingale restriction.
They also employ CAC 40 index options and show that the differences between the various
modifications of the CorradoSu model are minor, but could be economically significant in

2
specific cases. Corrado (2007) developed a martingale restriction that is hidden behind a
reduction in parameter space for the GramCharlier expansion coefficients. The resulting
restriction is invisible in the option price.
Although probability densities given by Gram-Charlier Type A series expansions are
as tractable as the Gaussian density, they have the drawback that they can yield negative
probability values. Jondeau and Rockinger (2001) developed numerical methods to impose
positivity constraints on the GramCharlier expansion. Rompolis and Tzavalis (2007) employ
a method to retrieve the risk neutral probability density function based on an exponential form
of a GramCharlier series expansion, known as type C GramCharlier expansion. This type of
expansion guarantees that the values of the risk neutral density will be always positive, but
there is no closed form formula for option values.
In general, from the GramCharlier type A density expansion, only the first two terms,
accounting for skewness and kurtosis, are kept in empirical studies related to option pricing. It
is quite probable, however, that including higher order terms in the expansion will produce a
decrease, rather, as one would expect, an increase in the performance of the option pricing
formula based on the Gram-Charlier type A expansion. This counterintuitive result is likely to
occur due to the lack of convergence of the Gram-Charlier type A expansion for heavy tailed
distributions that are of interest in finance, as it converges only if the probability density
function falls off faster than
( )
2
exp 4 x at infinity (Cramr, 1957).
The aim of this paper is to develop a new method to retrieve the risk-neutral
probability measure and to derive an option pricing formula by employing a modified Gram-
Charlier series expansion. Instead of using the probabilists Hermite polynomials, as in the
classical Gram-Charlier type A series expansion, we replace them by the physicists Hermite
polynomials. The main advantages of the new expansion consist in its convergence for heavy
tailed distributions and in the possibility of obtaining option prices in closed form.
The rest of the paper is structured as follows. In section 2 we present the classical and
the modified Gram-Charlier series expansion and analyze an example based on a widely used
distribution in finance, namely the Normal Inverse Gaussian (NIG) distribution. In section 3
we derive a pricing formula for European call options in the context of the modified Gram-
Charlier expansion. In section 4 we analyze various methods for obtaining the expansion
coefficients from observed option prices and present a simulation study based on the Heston
model. Although the contribution of the paper is methodological rather than empirical, we

3
also present, in section 4, a calibration exercise based on observed option data. The final
section concludes.

2. The Gram-Charlier and Gauss-Hermite series expansions
A probability density function ( ) p x with mean and standard deviation can be
represented as a GramCharlier Type A series expansion in the following form:
( )
0
1
n n
n
x x
p x z c He

=

| | | |
=
| |
\ \

(1)
where ( ) z x is the standard Gaussian density, ( )
n
He x denotes an nth-order probabilists
Hermite polynomial. These form an orthogonal basis on ( ) , + with respect to the weight
function
2
2
( )
x
w x e

= . The probabilists Hermite polynomials (Abramowitz and Stegun,

1964) are defined recursively by ( ) ( ) ( )
1 1 n n n
He x xHe x nHe x
+
= with ( )
0
1 He x = and
( )
1
He x x = . The expansion coefficients are given by ( )
1
!
n
x
c He p x dx
n

| |
=
|
\

and are,
in fact, a linear combination of the moments of the random variable with probability
distribution function ( ) p x , a property which is quite convenient when it comes to estimate
them.

Figure 1. The classical Gram-Charlier approximation of the NIG distribution
-4 -3 -2 -1 0 1 2
-2
-1
0
1
2
3
4
5
6
7
8
standard deviations
p
d
f


GC N=3
GC N=4
GC N=5
Gaussian
NIG

-4 -3 -2 -1 0 1 2
-4
-2
0
2
4
6
8
10
standard deviations
p
d
f


GC N=3
GC N=4
GC N=5
Gaussian
NIG

A B
The graphs depict the probability distribution function of the target distribution (NIG), of the Gaussian distribution, and the
Gram-Charlier approximations truncated after N=3,4,5 terms. In panel a the target distribution has mean -0.0012, standard
deviation 0.10, skewness -1.6 and excess kurtosis 5, and in panel b the target distribution has mean -0.005, standard deviation
0.20, skewness -2 and excess kurtosis 10.

4

The Gram-Charlier series expansion has poor convergence properties for heavy tailed
distributions (Cramer, 1957). In order to illustrate the divergence of this expansion we present
an illustrative example based on the Normal Inverse Gaussian (NIG) distribution. Figure 1
presents the Gram-Charlier approximations with an increasing number of terms in the
expansion and the exact NIG distribution for two sets of parameters. Figure 1a depicts a NIG
distribution with mean -0.0012, standard deviation 0.1, skewness -1.6 and excess kurtosis 5,
and figure 1b the case with mean -0.005, standard deviation 0.2, skewness -2 and excess
kurtosis 10. It is obvious that the series quickly becomes inaccurate by including a larger
number of terms. The parameters of the NIG distributions were obtained from the first four
cumulants using the method described in Eriksson, Forsberg and Ghysels (2004).
In fact, the Gram-Charlier expansion is a result of the expansion of the function
( ) ( ) p x z x in the basis of the probabilists Hermite polynomial. However, one could
choose another set of orthogonal polynomials as the basis of the expansion. In particular, the
physicists Hermite polynomials are employed in astrophysics (van der Marel and Franx,
1993). This yields a modified Gram-Charlier expansion or the so called Gauss-Hermite
expansion. A result in Myller-Lebedeff (1907) implies that the Gauss-Hermite expansion
converges even for heavy tailed distributions. More specifically, the convergence of the
expansion is assured if ( )
3
lim 0
x
x p x

= .
Therefore, a probability density function ( ) p x with mean and standard deviation
can be represented as a Gauss-Hermite (or modified GramCharlier) series expansion in
the following form:
( )
0
1
n n
n
x x
p x z a H

=

| | | |
=
| |
\ \

(2)
where ( )
n
H x denotes an nth-order physicists Hermite polynomial. These form an
orthogonal basis on ( ) , + with respect to the weight function
2
( )
x
w x e

= . The
physicists Hermite polynomials (Abramowitz and Stegun, 1964) are defined recursively by
( ) ( ) ( )
1 1
2 2
n n n
H x xH x nH x
+
= with ( )
0
1 H x = and ( )
1
2 H x x = .
Using the orthogonality condition of the physicists Hermite polynomials it follows
that the expansion coefficients are given by ( )
1
2 !
n n n
x x
a z H p x dx
n

| | | |
=
| |
\ \

.

5
These coefficients are no longer a linear combination of the moments, but of some weighted
moments, i.e.
n
x x
E z


(

| | | |
(
| |
\ \
(

, of the random variable with probability distribution
function ( ) p x . Later in the paper we will present some methods for calibrating these
expansions coefficients.
The improved convergence properties for heavy tailed distributions of the Gauss-
Hermite series expansion are illustrated in Figure 2, for the NIG distributions with the same
parameter sets as in the previous exercise.

Figure 2. The modified Gram-Charlier (Gauss-Hermite) approximation of the NIG distribution
-4 -3 -2 -1 0 1 2
0
1
2
3
4
5
6
standard deviations
p
d
f


Gauss-Hermite approx.
Gaussian
NIG

-4 -3 -2 -1 0 1 2
-7
-6
-5
-4
-3
-2
-1
0
1
2
standard deviations
l
o
g

p
d
f


Gauss-Hermite approx.
Gaussian
NIG

A
-4 -3 -2 -1 0 1 2
0
0.5
1
1.5
2
2.5
3
3.5
standard deviations
p
d
f


Gauss-Hermite approx.
Gaussian
NIG

-4 -3 -2 -1 0 1 2
-8
-7
-6
-5
-4
-3
-2
-1
0
1
2
standard deviations
l
o
g

p
d
f


Gauss-Hermite approx.
Gaussian
NIG

B
The graphs depict the probability distribution function (pdf) and the logarithm of the pdf of the target distribution (NIG), of
the Gaussian distribution, and the modified Gram-Charlier (Gauss-Hermite) approximation truncated after N=25 terms. In
panel a the target distribution has mean -0.0012, standard deviation 0.10, skewness -1.6 and excess kurtosis 5, and in panel b
the target distribution has mean -0.005, standard deviation 0.20, skewness -2 and excess kurtosis 10.

There is one drawback of the Gauss-Hermite approximation relative to the Gram-
Charlier approximation related to condition that the total mass of the density should be 1. Due

6
to the properties of the probabilists Hermite polynomials, in the Gram-Charlier
approximation this condition is satisfied independent of the number of terms used in the
approximation. On the other hand for the Gauss-Hermite series expansion the condition is
valid only in the limit since the requirement of unitary mass is equivalent to the identity
( )
2
0
2 !
1
!
k
k
k
a
k

=
=

. However, if the truncation is done after a large number of terms are

included, the mass of the distribution should be very close to 1. Alternatively one could
normalize the expansion coefficients such as the truncated sum adds to 1.
The following lemma points out that the characteristic function can also be easily
expanded using the same expansion coefficients.

Lemma 1. (Characteristic function representation) Consider a probability density
function ( ) p x with mean , standard deviation

and Gauss-Hermite expansion coefficients
( )
n
n
a
N
. Then the associated characteristic function can be written as:
( ) ( )
2
2
0
exp
2
n
n n
n
i a i H

=
| |
=
|
\

(3)
where 1 i = .

Proof: If one denotes by ( ) p x the standardized density, one has that ( )
1 x
p x p

| |
=
|
\
.
Using a well-known property of the physicists Hermite polynomials, namely
( )
2 2
2 2

n
x x
n
d
e H x x e
dx

| |
=
|
\

, the Gauss-Hermite expansion of ( ) p x can be written as
( ) ( ) ( ) ( )
0 0
n
n n n
n n
d
p x z x a H x a x z x
dx

= =
| |
= =
|
\

. Therefore, the Fourier transform of p is

( )
2 2
0 0
1 1
exp exp
2 2
n
n n
n n n
n n
d
a i a i H
d

= =
| |
| | | |
=
| | |
\ \
\

. The Fourier transform of p
follows immediately.
3. Option pricing
The Gauss-Hermite series expansion is an attractive alternative for approximating the
risk-neutral measure density and, as the following result points out, it allows for a closed form
formula for pricing European options.

7

Proposition 1. (Option pricing formula) Assume that the log-return risk-neutral
measure for time horizon is characterized by an annualized mean , an annualized
standard deviation and Gauss-Hermite expansion coefficients ( )
n
n
a
N
.
Then the premium at time t of an European call option with strike price K and maturity
t + is given by:
( )
1 2
, , , , , ,
q r
t t
c S K r q S e Ke



= (4)
where
t
S is the spot price of the underlying, r is the risk-free interest rate, q denotes the
dividend yield. We have
2
1
0
exp ( )
2
n n
n
r q a I

=

| |
= +
`
|
\ )

and
2
0
n n
n
a J

=
=

where
n
I and
n
J satisfy the recursion equations ( ) ( )
1 1 2 1
2 2 2
n n n n
I z d H d I nI
+
= + + and
( ) ( )
1 2 2 1
2 2
n n n
J z d H d nJ
+
= + with ( )
0 1
I N d = , ( ) ( )
1 1 1
2 2 I z d N d = + ,
( )
0 2
J N d = , ( )
1 2
2 J z d = ,
( ) ( )
2
1
log
t
S K
d


+ +
= ,
2 1
d d = , and ( ) N is the
cumulative distribution function of the standard Gaussian distribution.

Proof: If one denotes by ( )
t t
p S
+ +
the terminal underlying asset price risk-neutral density
and by ( ) p x the standardized log-return risk-neutral density then we have that:
( ) ( ) ( ) , , , , , , max , 0
r
t t t t t
c S K r q e S K p S dS

+ + + +

( )
( ) max , 0
r x
t
e S e K p x dx

( )
( )
2
1 2
r x q r
t t
d
e S e K p x dx S e Ke

= =

with ( )
2
( )
1
r q x
d
e e p x dx

and ( )
2
2
d
p x dx

.
Taking into account the Gauss-Hermite expansion of the log-return risk-neutral density, one
has that
2
1
0
exp ( )
2
n n
n
r q a I

=

| |
= +
`
|
\ )

with ( ) ( )
2
2
2
x
n n
d
I e e z x H x dx

= =

( )
( ) ( ) ( )
( )
2
1 2

2

x
n n
d d
e e z x H x dx H x z x dx

+

+ + = +

and

8
2
0
n n
n
a J

=
=

with ( ) ( )
2
n n
d
J H x z x dx

. Using the properties of Gauss-Hermite

polynomials namely ( ) ( ) ( )
1 1
2 2
n n n
H x x H x n H x
+
= , ( )
'
1
2 ( )
n n
H x n H x

= and integration
by parts, one can obtain the recursion equations for
n
I and
n
J as follows:
( )
( )
( ) ( ) ( )
( )
1 1
1 1
2
n n n n
d d
I H x z x dx x H x H x z x dx

+ +

(
= + = + + +



( )
( )
( )
( )
( )
( )
1 1 1
2 2
n n n
d d d
H x z x dx H x z x dx H x z x dx


= + + + +


( )
( )
1 1 1
2 2 2
n n n
H d z d I nI

= + + + where we have used '( ) ( ) z x xz x = .
( ) ( ) ( ) ( ) ( )
2 2
1 1
2
n n n n
d d
J H x z x dx xH x H x z x dx

+ +

= = (

( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )
2 2
2 2 2 2 1
2 2 2
n n n n
d d
H d z d H x z x dx H d z d n H x z x dx

= + = +


( ) ( )
2 2 1
2 2
n n
H d z d nJ

= + .
Finally, we have ( ) ( )
1
0 1
d
I z x dx N d

= =

and similarly ( ) ( )
2
0 2
d
J z x dx N d

= =

.
Remark 1. If one assumes that the risk neutral measure density is normal then the
Gauss-Hermite expansion coefficients are given by
0
1 a = and 0
n
a = , 1 n and, therefore,
equation (4) reduces to the Black-Scholes-Merton formula.

When using series expansions to approximate risk-neutral densities one has to
determine the martingale restriction associated to that expansion. Lemma 1 allows us to easily
derive the martingale restriction in the case of the Gauss-Hermite expansion.

Corollary 1. (Martingale restriction) Assume that the log-return risk-neutral measure
for time horizon is characterized by an annualized mean , an annualized standard
deviation , and Gauss-Hermite expansion coefficients ( )
n
n
a
N
. Given that r is the risk-free
interest rate and q denotes the dividend yield then the martingale restriction associated to the
Gauss-Hermite expansion is:

9

( )
2
0
exp ( ) 1
2
n
n n
n
r q a i H i

=

| |
+ =
`
|
\ )

(5)
Proof: The martinagle condition requires
r q
t t
E e S e S

+
( =

. Denoting by the Fourier
transform of the log-return risk-neutral measure density, the result follows immediately from
Lemma 1 since ( ) { }
( ) r q r q
t t
E e S e S e i

+
( =


4. Calibrating the expansion coefficients to option data
Before presenting the result relating the expansion coefficients to observed option
data, it is interesting to point out that the Gauss-Hermite expansion coefficients could be
computed from the associated characteristic function. More specifically, from equation (3)
and from the orthogonality condition of the physicists Hermite polynomials it follows that
the expansion coefficients of a density with mean , standard deviation and characteristic
function can be represented as:
( )
2
1
exp exp
2
2 !
n n
n n
a H i d
n i

| |
| | | |
=
| | |
\ \
\

(6)
Therefore, given an option pricing model for which the characteristic function is
known, such as the Heston model, equation (6) together with equation (4) provide an
alternative method of obtaining option prices.
We now show how to obtain the Gauss-Hermite expansion coefficients from option
market prices. The following proposition states the result.

Proposition 2. (Calibration to option data) Given option prices for time horizon
and given that the log-return risk-neutral measure density for time horizon is characterized
by an annualized mean and an annualized standard deviation then the Gauss-Hermite
expansion coefficients can be computed as:


( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
( )
( ) ( )
2 2 1
0
2 !
, , , ,
r q
t
r q
t
r q r q
n t n t n
S e
r
n t n t
S e
a z d S e H d S e
n
e F K c S K dK F K p S K dK

= +

(

( + +
`
(

)

(7)

10
where
2
log
( )
t
S
K
d K

| |
+
|
\
= ,
t
S is the spot price of the underlying, r is the risk-free
interest rate, q is the dividend yield, ( ) , ,
t
c S K and ( ) , ,
t
p S K denotes the premium at time
t of an European call and put, respectively, with strike price K and maturity t + and the
function ( )
n
F is given by

( )
( )
( )
( )
( )
( )
2 2
2 2 2 2 1 2 2 2 2 2
2
( )
1 4 4 ( 1) ( )
n n n n
z d
F K d d H d nd H d n n H d n
K



= + +

Proof: One has that ( )
1
2 !
n n n
x x
a z H p x dx
n

| | | |
=
| |
\ \

where ( ) p x log-return
risk-neutral measure density for time horizon . By a change of variable we obtain that
( ) ( )
1
0
2 !
n n t t t t n
a G S p S dS
n

+ + + +
=

where ( )
t t
p S
+ +
is the terminal underlying asset price
risk-neutral density and ( )
( ) ( ) log log
t t
n n
S S S S
G S z H


| | | |
=
| |
\ \
. The proposition
follows in a straightforward way from a general result in Bakshi, Kapadia and Madan (2003)
based on the fact that any function with bounded expectations can be spanned by a continuum
of OTM European call and put options (Bakshi and Madan, 2000). More specifically, one has
to apply equation (3) in Bakshi, Kapadia and Madan (2003) to the function ( )
n
G S .
Remark 2. In order to implement equation (7) one needs the mean and the standard
deviation of the log-return risk-neutral measure density. These can be computed using the
method described in Bakshi, Kapadia and Madan (2003).
In what follows we conduct a series of calibration exercises in order to investigate the
performance of the option pricing model based on the Gauss-Hermite approximation to
adequately reflect the observed volatility smile.
4.1. Calibration to simulated option data
In order to simulate the option prices we employ the Heston stochastic volatility model with
the following parameter values: 4.25 k = , 0.08 = , 0.8 = , 0.85 = and
0
0.03 v = .
These values are similar to those obtained in Gourier, Bardgett and Leippold (2012) by
calibrating the Heston model to all S&P 500 index options traded on 21 October 2010. We

11
assume that the current underlying price is 100 and we generate a set of 3 months European
call and put option prices with strike prices between 35 and 155 with a step of 2.5 units. The
risk-free interest rate is set to 0.05 r = and the dividend yield to 0.03 q = . Since the
characteristic function of the Heston model is known in closed form we can compute the
expansion coefficients either by using equation (6) or directly from the generated option
pricing using (7). In all the computation we truncated the Gauss-Hermite expansion after
N=25 terms. Figure 3 depicts the approximated density and in the case the expansion
coefficients are computed using the characteristic function (panel a) or are inferred from
option prices (panel b).
Figure 3. The Gauss-Hermite approximation of the Heston model distribution
-4 -3 -2 -1 0 1 2
0
1
2
3
4
5
6
standard deviations
p
d
f


Gauss-Hermite approx.
Heston
Gaussian

-4 -3 -2 -1 0 1 2
-7
-6
-5
-4
-3
-2
-1
0
1
2
standard deviations
l
o
g

p
d
f


Gauss-Hermite approx.
Heston
Gaussian

a
-4 -3 -2 -1 0 1 2
0
1
2
3
4
5
6
standard deviations
p
d
f


Gauss-Hermite approx.
Heston
Gaussian

-4 -3 -2 -1 0 1 2
-7
-6
-5
-4
-3
-2
-1
0
1
2
standard deviations
l
o
g

p
d
f


Gauss-Hermite approx.
Heston
Gaussian

b
The graphs depict the probability distribution function (pdf) and the logarithm of the pdf of the target distribution (Heston
model), of the Gaussian distribution, and the modified Gram-Charlier (Gauss-Hermite) approximation truncated after N=25
terms. In panel a the expansion coefficients are computed using the characteristic function, and in panel b are inferred from
the simulated option prices.

Next we employed the option pricing formula (4) truncated after N=25 terms and
derived the implied volatility curve as depicted in Figure 4. In panel a the expansion

12
coefficients are computed using the characteristic function, and in panel b they are estimated
from option prices. We do not constrain the coefficients in order to observe the martingale
restriction. However, the truncated sum in equation (5) is quite close to 1 being equal to
1.002.

Figure 4. Implied volatility curves inferred from simulated option prices
-0.5 -0.4 -0.3 -0.2 -0.1 0 0.1 0.2
0.1
0.15
0.2
0.25
0.3
0.35
0.4
0.45
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
log (K/F)


IV Heston
IV Gauss-Hermite approx.

-0.5 -0.4 -0.3 -0.2 -0.1 0 0.1 0.2
0.1
0.15
0.2
0.25
0.3
0.35
0.4
0.45
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
log (K/F)


IV Heston
IV Gauss-Hermite approx.

a b
The graphs depict the implied volatility curves of the Heston model and of the option pricing model based on the Gauss-
Hermite approximation truncated after N=25 terms. In panel a the expansion coefficients are computed using the
characteristic function, and in panel b are inferred from the simulated option prices

The Gauss-Hermite implied volatility curve is a good approximation of the Heston
model one for a range of strike prices spanning five standard deviations of the log-return risk-
neutral density, four standard deviations to the left and one to the right of the mean return or,
equivalently, for log( ) K F in the interval (-0.4, 0.1), where F is the forward price.
4.2. Calibration to market option data
In this section we employ market data about European options in order to infer the
implied volatility curve of option pricing model based on the Gauss-Hermite approximation.
More specifically, we focus on SPX options quotes on 15 September 2011, the day before
triple-witching, and compute implied volatilities for maturities of 1 month and 3 months. The
implied volatility surface on this specific date was also analysed by Gatheral and Jacquier
(2012) with a SVI parameterization. Data on option prices, the term structure of interest rate
and the dividend yield on this specific date are obtained from OptionMetrics. In order to
estimate the expansion coefficients, we determined the implied volatilities associated to mid
prices of the put options and then the call and put prices that appear in the integrals in
equation (7) are computed by interpolation. We employed the option pricing formula (4)

13
truncated after N=15 terms. We do not constrain the coefficients in order to impose the
martingale restriction and the truncated sum in equation (5) is around 1.006. The resulting
implied volatility curves of the Gauss-Hermite approximation are depicted in Figure 5.

Figure 5. Implied volatility curves inferred from market option prices
-0.4 -0.3 -0.2 -0.1 0 0.1 0.2
0.2
0.3
0.4
0.5
0.6
0.7
0.8
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
log (K/F)


IV Gauss-Hermite approx.
IV bid
IV ask

-1 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4
0.2
0.25
0.3
0.35
0.4
0.45
0.5
0.55
0.6
0.65
0.7
i
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
log (K/F)


IV Gauss-Hermite approx.
IV bid
IV ask

1 month 3 months
The graphs depict the implied volatility curves for 1 month and 3 months of the option pricing model based on the Gauss-
Hermite approximation truncated after N=15 terms.

The Gauss-Hermite approximation seems to perform quite well for an interval of
strike prices that spans more than five standard deviations of the log-return risk-neutral
density, four standard deviations to the left and one and a half to the right of the mean return
or for a log( ) K F in the interval (-0.4, 0.15) for 1 month maturity and in the interval (-0.8,
0.3) for 3 months maturity.
5. Concluding remarks
In this paper we developed a new method to retrieve the risk-neutral measure density
from option prices using the Gauss-Hermite series expansion around the Gaussian density and
pointed out its better convergence properties compared to the Gram-Charlier expansion. We
also derived several methods for obtaining the expansion coefficients. More specifically, one
can obtain the coefficients of the Gauss-Hermite expansion from the probability distribution
function, from the characteristic function, or directly from market option prices.
Approximating the risk-neutral density using the Gauss-Hermite expansion is quite
appealing because it allows for a closed form option pricing model that embeds the classical
Black-Scholes-Merton formula. This option pricing formula based on the Gauss-Hermite
expansion is an alternative to the inverse Fourier transform methodology and is quite general

14
since it can be employed for models with the probability distribution function known in
closed form, for models with the characteristic function known in closed form, and can also
be calibrated to market option prices.
We calibrated the new option pricing model to option prices simulated using Heston
stochastic volatility model and to market option prices. These calibration exercises have
revealed that the resulting implied volatility curves are quite accurate for a range of strike
prices that spans five standard deviations of the log-return risk-neutral density, four standard
deviations to the left and one to the right of the mean return.

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