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Group 7

Rahul Shakya
Rahul Yadav

The Jump Diffusion Model


The jump diffusion model, introduced in 1976 by Robert Merton, is
a model for stock price behaviour that incorporates small day-today "diffusive" movements together with larger, randomly
occurring "jumps".
The inclusion of jumps allows for more realistic "crash" scenarios
and means that the standard dynamic replication hedging
approach of the standard Black-Scholes model no longer works.
This causes option prices to increase compared to the BlackScholes model and to depend on the risk aversion of investors.

In the jump diffusion model, the stock price St follows the random process .

The first two terms are familiar from the Black-Scholes model: drift rate , volatility ,
and random walk (Wiener process) .
The last term represents the jumps: J is the jump size as a multiple of stock price while
N(t) is the number of jump events that have occurred up to time t. N(t) is assumed to
follow the Poisson process

where is the average number of jumps per unit time. The jump size may follow any
distribution, but a common choice is a log-normal distribution ,

where N(0,1) is the standard normal distribution, m is the average jump size, and v is
the volatility of jump size.
The three parameters (, m, v) characterize the jump diffusion model.

For European call and put options, closed-form solutions for the
price can be found within the jump diffusion model in terms of
Black-Scholes prices.
If we writePBS ( S , K , r , T )
as the Black-Scholes price of a call or
put option with spot S, strike K , volatility , interest rate r
(assumed constant for simplicity), and time to expiry T, then the
corresponding price within the jump diffusion model can be
written as:

where
and
.
Kth
The
term in this series corresponds to the scenario where k
jumps occur during the life of the option.

Assumptions/Limitations
The BlackScholes model does not talk much about two
mentioned features which JDM addresses
(1)The asymmetric leptokurtic features i.e. in a BSM the
distribution is skewed to the left and has a higher peak
than a normal distribution
(2)The volatility smile- In BSM it is assumed that the
volatility is constant which is not a real world case. In
reality, it is widely recognized that the implied volatility
curve resembles a smile, meaning it is a convex curve
of the strike price.

A generalization
Below is a pricing formula which Merton produced which would be
applied when the stock price follows a diffusion process overlaid
with random jumps

dp is the Poisson random jump


k is the expected size of the jump
dt is the probability that a jump occurs in the next interval of length dt
dz is a Wiener process
dp and dz are independent
q dividend yields

What is Stochastic Volatility Model


Stochastic volatility models for options were developed out of
a need to modify the Black Scholes model for option pricing,
which failed to effectively take the volatility in the price of
the underlying security into account.
The Black Scholes model assumed that the volatility of the
underlying security is constant, while Stochastic volatility
models categorized the price of the underlying security as a
random variable.
Allowing the price to vary in the stochastic volatility models
improved the accuracy of calculations and forecasts

Basic Model

Starting from a constant volatility approach, assume that the


derivative's underlying price follows a standard model
forgeometric brownian motion:
dSt = St dt + St dWt
Where,
, is the constant drift (i.e. expected return) of the security price S t,
is the constant volatility
dWt is a standard Wiener process with zero mean and unit rate of
variance.

The explicit solution of this stochastic differential equation is:

Example
Suppose that during a 1-year period, the volatility will
be 20% during the first 6 months and 30% during
second 6 months.
The average variance rate is:
0.5 X 0.20 + 0.5 X 0.30 = 0.065
It is correct to use Black-Scholes-Merton with a variance
rate of 0.065.
This corresponds to a volatility of
(0.065) = 0.255, or 25.5%

Some Other Stochastic Volatility


Models are:
Heston model
CEV Model
SABR volatility mode
GARCH model
3/2 model
Chen model