Pricing European options with non-normal log-returns: a simulation study

Abstract

<p>This study examines the limitations of the Black-Scholes (B-S) model, which assumes normality in log-return distributions, by exploring alternative non-normal distributions that better capture the observed kurtosis and skewness. Through the incorporation of these distributions into a Discrete-Time stochastic process model, the study investigates their impact on option pricing compared to the traditional B-S model. Employing Monte Carlo simulation techniques, call and put option prices are estimated under various log-return distributions adhering to the risk-neutral paradigm, and the simulated prices are compared using relative difference curves. <br>The findings demonstrate that deviations from normality in log-return distributions significantly affect option pricing, emphasizing the need for financial professionals to employ more sophisticated models that accurately represent the statistical profiles of diverse assets.<br></p>