Abstract

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The Impact of Return Nonnormality on Exchange Options

Minqiang Li
Georgia Institute of Technology - College of Management

Journal of Futures Markets, Vol. 28, No. 9, pp. 845-870, 2008

Abstract:
The Margrabe formula is used extensively by theorists and practitioners not only on exchange options, but also on executive compensation schemes, real options, weather and commodity derivatives, etc. However, the crucial assumption of bivariate normal distribution is not fully satisfied in almost all applications. We study the impact of nonnormality on exchange options by using a bivariate Gram-Charlier approximation. For near-the-money exchange options, skewness and coskewness induce price corrections which are linear in moneyness, while kurtosis and cokurtosis induce quadratic price corrections. The nonnormality helps to explain the implied correlation smile observed in practice.

Keywords: multivariate Gram-Charlier approximation, nonnormality, exchange option, Margrabe formula

JEL Classifications: C14, G12, G13

Accepted Paper Series

Date posted: February 07, 2008 ; Last revised: October 08, 2009

Suggested Citation

Li, Minqiang, The Impact of Return Nonnormality on Exchange Options. Journal of Futures Markets, Vol. 28, No. 9, pp. 845-870, 2008. Available at SSRN: http://ssrn.com/abstract=1091062

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Contact Information

Minqiang Li (Contact Author)

Georgia Institute of Technology - College of Management ( email )

800 West Peachtree St., NW
Atlanta, GA 30308-1149
United States
404-894-4926 (Phone)
404-894-6030 (Fax)

HOME PAGE: http://mgt.gatech.edu/directory/li.html