What is ‘Gamma Pricing Model’
An equation for determining the fair market value of a European-style option when the price movement on the underlying asset does not resemble a normal distribution. The gamma pricing model is intended to price options where the underlying asset has a distribution that is either long-tailed or skewed, where dramatic market moves occur with greater frequency than would be predicted by a normal distribution of returns.
Explaining ‘Gamma Pricing Model’
While the Black-Scholes option pricing model is the best known, it does not provide accurate pricing results under all situations. In particular, the Black-Scholes model assumes that the underlying instrument has returns that are normally distributed. As a result, the Black-Scholes will misprice options on instruments that do not trade based on a normal distribution. Many alternative options pricing methods have been developed with the goal of providing more accurate pricing for real-world applications such as the Gamma Pricing Model. Generally speaking, the Gamma Pricing Model measures the gamma, which is how much fast the delta changes with respect to small changes in the underlying asset’s price.
Further Reading
- The variance gamma process and option pricing – academic.oup.com [PDF]
- The variance gamma (VG) model for share market returns – www.jstor.org [PDF]
- An empirical test of the variance gamma option pricing model – www.sciencedirect.com [PDF]
- An empirical examination of the variance‐gamma model for foreign currency options – www.jstor.org [PDF]
- Asian options, the sum of lognormals, and the reciprocal gamma distribution – www.worldscientific.com [PDF]
- A conditional autoregressive range model with gamma distribution for financial volatility modelling – www.sciencedirect.com [PDF]
- Option pricing using variance gamma Markov chains – link.springer.com [PDF]
- The entropy theory of stock option pricing – www.worldscientific.com [PDF]
