An Empirical Model for Volatility of Returns and Option Pricing

TL;DR

This paper proposes a new option pricing model based on exponential return distributions, addressing limitations of the Black-Scholes model and aligning better with empirical data on asset returns.

Contribution

It introduces a modified Fokker-Planck approach to model exponential returns and derives a new option pricing framework that matches observed market data.

Findings

Exponential distribution models asset returns more accurately than Gaussian.

The new model aligns well with trader valuations.

A method to interpolate between exponential and Gaussian returns is developed.

Abstract

In a seminal paper in 1973, Black and Scholes argued how expected distributions of stock prices can be used to price options. Their model assumed a directed random motion for the returns and consequently a lognormal distribution of asset prices after a finite time. We point out two problems with their formulation. First, we show that the option valuation is not uniquely determined; in particular, stratergies based on the delta-hedge and CAMP (Capital Asset Pricing Model) are shown to provide different valuations of an option. Second, asset returns are known not to be Gaussian distributed. Empirically, distributions of returns are seen to be much better approximated by an exponential distribution. This exponential distribution of asset prices can be used to develop a new pricing model for options that is shown to provide valuations that agree very well with those used by traders. We show how the Fokker-Planck formulation of fluctuations (i.e., the dynamics of the distribution) can be modified to provide an exponential distribution for returns. We also show how a singular volatility can be used to go smoothly from exponential to Gaussian returns and thereby illustrate why exponential returns cannot be reached perturbatively starting from Gaussian ones, and explain how the theory of 'stochastic volatility' can be obtained from our model by making a bad approximation. Finally, we show how to calculate put and call prices for a stretched exponential density.