**Background**

The derivative pricing model developed by Black, Scholes and Merton is a huge success in financial engineering area. It says that there exists an arbitrage-free price for plain vanilla options and the investors can perfectly hedge them by constructing a self-finance portfolio. However, the empirical observation demonstrates that this model is not perfect. For one thing, two different options on the same underlying with the same expiry date but different strike prices can imply different volatility. Indeed, if one plots the implied volatility as a function of the strike price of an option, the curve is roughly smile-shaped. For another thing, the stock and foreign exchange prices are simply not log-normally distributed as the model assumes. And in fact, the actual distribution of the logs of asset price changes have fat tails. To cope with these problems, we need to introduce more sophisticated models.

**Introduction**

A big shortcoming of Black-Scholes model is that it assumes the asset price is a continuous function. But in reality, the stock market undergoes crash periodically. We, therefore, wish to permit the possibility of jumps in our model. In this post, we briefly discuss the jump-diffusion model presented by Merton. And in order to illustrate it, we first briefly discuss the properties of Poisson process.

**Poisson process**

The Poisson process with intensity *lambda* counts the number of jumps that occur at or before time *t* and its distribution is

Its increments are stationary and independent. The expectation of the increment is

The variance is the same as the mean

We define the compensated Poisson process as

Then *M*(*t*) is a martingale.

Now let *Y*1, *Y*2,… be a sequence of identically distributed random variables with mean *Beta*=E*Yi*. We assume the random variables *Y*1, *Y*2,… are independent of one another and also independent of the Poisson process *N*(*t*). We define the compound Poisson process

Like the simple Poisson process, the increments of the compound Poisson process are stationary and independent, and the expectation is

If we define the compensated compound Poisson process as

then it is a martingale.

**Asset driven by a Brownian motion and a compound Poisson process**

In this section, the stock price will be modeled by the stochastic differential equation

where *S *is the stock price, *W*(*t*) is a Brownian motion, and *Q*(*t*) is a compound Poisson process. *Lambda* is the intensity of the jump and *Beta *is the expectation of the jump size *Yi*.

Under the original probability measure, the mean rate of return on the stock is *a*. We assume that the jump size *yi *> -1 for* i *= 1,…, *M* in order to guarantees that although the stock price can jump down, it cannot jump from a positive to a negative value or to zero. We begin with a positive initial stock price *S*(0), and the stock price is positive at all subsequent times.

By the property of Doleans-Dade exponential, one can find that the solution to the above SDE as

We now undertake to construct a risk-neutral measure. The probability measure is risk-neutral if and only if

This is equivalent to the equation

which is the market price of risk equation for this model. Here the letters with tilt represent the corresponding variables in risk-neutral world. Obviously, there is no unique risk-neutral measure in this situation because one can find infinitely many combinations satisfying the market price of risk equation. One can choose a risk-neutral measure by matching the market. Here, we assume a certain risk-neutral measure is chosen.

**Closed form formula for European call option**

A jump-diffusion model with a continuous jump distribution was first treated by Merton, who considered the case in which one plus the jump size has a log-normal distribution

For the next step, we need some notation. Define

where

and

is the cumulative standard normal distribution function. In other words,*kappa*(*tau*, *x*, *r*, *sigma*) is the standard Black-Scholes-Merton call price on a geometric Brownian motion with volatility *sigma* when the current stock price is *x*, the expiration date is *tau* time units in the future, the interest rate is *r*, and the strike price is *K*.

Now define *tau* = *T *– *t. *We give the closed-form formula for the European Call option without proof

With a little work, the price can be rewritten as

where

These formulas were originally derived by Merton using PDE approach. Although the formula is an infinite series, it converges very fast and the first several terms can produce quite good approximation.

**Jump-diffusion smile**

In this part we discuss about the properties associated with the volatility smile generated by jump-diffusion model. It is straightforward that an option on a stock with a jump component is more valuable than an option on a stock without jump component. In fact, the effect of adding jumps can give rise to a heavy tail for the distribution of log stock price. Therefore, the out-of-money options become more valuable, a consequence leading to an implied-volatility smile.

The jump intensity *lambda tilt* controls the frequency of the happening of jumps. Increasing intensity makes the stock price more volatile, and thus the smile shape become steeper. On the other hand, the lower the jump intensity is, the flatter the smile would be. Also, the smile will be much sharper for short-term maturities. Over long time periods, the smile becomes more horizontal as the diffusive component of the model becomes dominant. See Figures 1 and 2.

**Figure ****1** Jump-diffusion smiles for time horizons of one through three years. Spot is 110, jump intensity is 0.1, and jump size are log-normal distributed with mean equal to -1.

The distribution of jump size *Y* determines the shape of volatility smile. Using symmetric distribution of jumps will lead to a symmetric smile shape. While if we let jump size follows a log-normal distribution, like what we use in this post, the smile becomes downwards sloping. The parameter *mu* can affect the skewness of the smile. Usually, we pick *mu* < 0, which means the stock price more likely goes down when jump occurs. This causes a downwards sloping smile. If we let* mu* > 0, the smile becomes upwards sloping for large *moneyness*. See Figure 2 and 3.

**Figure ****2** Jump-diffusion smiles for time horizons of one through three years. Spot is 110, jump intensity is 0.01, and jump size are log-normal distributed with mean equal to -1.

**Figure ****3** Jump-diffusion smiles for time horizons of one through three years. Spot is 110, jump intensity is 0.01, and jump size are log-normal distributed with mean equal to 1.

I have implemented the final closed-form formula for pricing European options in an Excel add-in. One can use the functions in this library to check the shape of "volatility smile" generated by the model as what I did in the last part of the article. One can download this Excel add-in from the following link below. Add it into your Excel (only for windows system) it's free to use!- (by- Xiaohong Chen, May 2015 Graduate, Financial Math Intern, Career Ambassador)

**Reference**

[1] |
F. Black and M. Scholes, “The Pricing of Options and Corporate Liabilities,” *Journal of Political Economy, *vol. 81, pp. 637-659, May/June 1973. |

[2] |
R. C. Merton, “Theory of Rational Option Pricing,” *Bell Journal of Economics and Management Science, *vol. 4, pp. 141-183, Spring 1973. |

[3] |
R. C. Merton, “Option Pricing When Underlying Stock Returns Are Discontinuous,” *Journal of Financial Economics, *vol. 3, pp. 125-44, March 1976. |

[4] |
M. Joshi, The Concepts and Practice of Mathematical Finance, Cambridge University Press, 2003. |

[5] |
J. C. Hull, Options, Futures, And Other Derivatives, Pearson Education Limited, 2012. |

[6] |
S. E. Shreve, Stochastic Calculus for Finance II, Springer Science+Business Media, LLC, 2004. |