European Option Pricing Under Generalized Tempered Stable Process: Empirical Analysis

Abstract

The paper investigates the performance of the European option price when the log asset price follows a rich class of Generalized Tempered Stable (GTS) distribution. The GTS distribution is an alternative to Normal distribution and $\alpha$-Stable distribution for modeling asset return and many physical and economic systems. The data used to compute the option price comes from fitting the GTS distribution to the underlying daily SPY ETF return distribution. The Esscher transform method preserves the structure of the GTS process. Both the extended Black-Scholes formula and the Generalized Black-Scholes Formula are used in the study. The 12-point rule Composite Newton-Cotes Quadrature and the Fractional Fast Fourier (FRFT) algorithms were implemented and produce the same European option price at two decimal places. Compared to the option price under the GTS distribution, the Black-Scholes (BS) model is underpriced for the Near-The-Money (NTM) and the in-the-money (ITM) options. However, the BS model and GTS European options yield almost the same option price for the deep out-of-the-money (OTM) and the deep-in-the-money (ITM) options.Comment: 12 pag