Option pricing and hedging beyond Black-Scholes

23 _
Erik Aurell , Jean-Philippe Bouchaud ; , Marc Potters and Karol Zyczkowski
1 3 4

January 14, 1997

1
Articial Economy Project,
Center for Parallel Computers, KTH,
S-100 44 Stockholm, SWEDEN
E-mail: eaurell@pdc.kth.se
2
Service de Physique de l'etat Condense,
Centre d'etudes de Saclay, Orme des Merisiers,
91191 Gif-sur-Yvette Cedex, FRANCE
E-mail: bouchau@amoco.saclay.cea.fr
3
Science & Finance, 109-111 rue Victor Hugo,
92523 Levallois Cedex, FRANCE
4
Dept. of Physics, Jagiellonian University,
ul. Reymonta 4, PL-30 057 Krakow, POLAND
E-mail: karol@castor.if.uj.edu.pl
Abstract
We introduce a prescription how to price options on a stock or commodity, in a situation where
risk in options' trading cannot be eliminated by hedging. First, a hedging strategy is found in
such a way that risk is made as small as possible. The remaining residual risk is an important
quantity which we can compute. Second, the option price is determined by the condition that the
expected return of an operator using the risk-minimizing hedging strategy is zero. We compare
our prescription with historical Bund call options on the LIFFE market, with very satisfactory
agreement.

Keywords: Option pricing, inherently risky options, mean-variance hedging, Bund call options
JEL classication: G13, G14

1
1 Introduction
The famous Black and Scholes theory of option pricing has two remarkable features: The hedging
strategy eliminates risk entirely, and the option price does not depend at all on the average return of
the underlying asset.
Although everyone agrees that the geometrical Brownian motion model of stock prices considered
by Black and Scholes (1973) is only a rough rst approximation to the real world, there is no consensus
on how to price an option in a more general, hopefully more realistic, model.
It is important to realize that in most models of stock price movements, except a few special cases
(of which the geometrical Brownian model is one), risk in option trading cannot be eliminated. Even
in the geometrical Brownian model, risk cannot be eliminated if trading is only allowed at discrete
times, as noted already by Black and Scholes themselves (1973, pp. 642-643). Arbitrage arguments
hence cannot be used to x the option price in a general price movement model.
The problem of pricing inherently risky options has been addressed quite frequently in the nance
literature, and obviously also by practitioners, for whom it is a fact of life. Broadly speaking, one
can nd two main approaches in the published literature (see, e.g. Hull (1994)). The rst consists of
various more or less ad hoc modications of the basic Black-Scholes formula, where, in particular, the
volatility of the stock is adjusted to account in some way for risk, and also for trading costs. Three
examples of such an approach are the well-known papers by Leland (1985) and Figlewski (1989),
and the recent contribution of Avellaneda (1996). These prescriptions have the great advantage of
simplicity and computability, but they lack clear theoretical support. Furthermore, the problem of
the residual risk is rarely discussed.
A second, more academic, approach involves the introduction utility functions describing agents on
the market, and an option pricing procedure that follows from maximization of the utility functions.
The whole basis of this construction is not entirely convincing. Utility functions have an honoured
place in the tradition of theoretical economy, but it is not obvious that they are relevant to the
immediate practical problem, for a given economic agent, of giving a price of an option on the market,
and this option price is furthermore somewhat arbitrary, as arbitrary as the utility function considered.
Nevertheless, advanced mathematical theory has been developed along this path, see Davis (1993).
Its numerical implementation demand state-of-the-art techniques, at present only available to a very
select audience, c.f. Ishii & Lions (1990). The practical value of the results obtained in this approach
so far is questionable.
We want here to present a new approach to the pricing of risky options, which works equally well
when risk cannot be eliminated, and which is a natural generalisation of the classical Black-Scholes
recipe. It can be described by two conditions:
 An optimal hedging strategy is found by minimizing risk over all possible trading strategies.
 The price of the option is such that the average prot of an agent using the optimal hedge is
zero.
A mathematical formulation of these two conditions and what follows from them is given in the
next section.
The general idea of judging nancial investment strategies by both their expected return and their
risk gained theoretical support by the development of the Capital Asset Pricing Model by Sharpe
(1964,1965) and Litner (1965). A recent overview can be found in the text-book by Sharpe (1985).
To our knowledge, in the context of the pricing of derivative securities, risk-minimization arguments
were rst introduced by Follmer and Sondermann (1986,1988). Further development of this mathe-
matical theory has been carried out by CERMA (1988), Schal (1994), Schweizer (1995) and Mercurio
(1995,1996).
The prescription to price options by minimizing risk was independently proposed by one of us in

2
Bouchaud & Sornette (1994). It was thereafter also derived as the equilibrium price on a market with
_
dierent types of agents, characterized by dierent attitudes to risk in Aurell & Zyczkowski (1996). A
further discussion of the theoretical background of the prescription is beyond the present paper. We
will instead work out concrete formulae and consequences for practical option pricing, and compare
with empirical market data from the LIFFE Options Exchange.
Let us note that in our option price prescription there is no xed market price for residual risk.
However, from this observation it does not at all follow that our prescription coincides with Black-
Scholes. When risk cannot be eliminated, there will be an optimal hedge that minimizes risk, but
this hedge does not need to be, and in general is not, a Black-Scholes portfolio. The price xed by
the condition that the average prot of the optimal hedge is zero, is thus in general dierent from the
Black-Scholes option price. For example, an important qualitative dierence with Black and Scholes
is that our option price prescription in general does depend on the average return of the asset. Finally,
the very existence of a non-zero risk is related to the presence of (rather large) `bid/ask' spreads on
option markets, which re ect the need (for the writer of the option) to protect himself at least partially
against this risk. In other words, the value of the residual risk can be used to rationalize the amplitude
of the bid/ask spread.
We will thus demonstrate that both the remarkable features of the Black-Scholes option pricing,
that risk can be eliminated, and that the price does not depend on the average return, are not inherent
to rational option pricing as such, but are tied to the specic log-Brownian price movement model.

2 Global wealth balance

As the basic building blocks we take the average value and the standard deviation of a global wealth
balance. Following Sharpe (1964) we refer to these two quantities as the prot and the risk.
We will for concreteness write out the global wealth balance of a writer of a European call option.
The balance for a buyer of a European call option is quite similar, and can be found in Aurell &
_
Zyczkowski (1996). The generalization to other European options is straight-forward, and is covered
in Bouchaud & Sornette (1994) and Bouchaud et al (1996). The generalization to American options
is not completely obvious in theory, but it can be shown that the rational price of an American call
option is the same as that of the corresponding European call option1 , while there is a dierence for
put options in the presence of a non zero interest rate (Bouchaud et al (1996)). However, for short
term options, this dierence is rather small. Finally we will not here introduce transaction costs. They
could easily be included in the balance equation, but the optimal hedge would have to be found either
by perturbation theory in the transaction costs or by a numerical procedure, and not in explicit form.
For clarity of presentation we will therefore here stick to the case of no market friction.
Let us now turn to the description of the balance equation. At time t = 0, the writer receives the
price of the option C [x0; xc ; T ], on a certain asset the value of which is x(t = 0) = x0. The strike price
is xc . Between t = 0 and t = T , the writer may trade the asset at discrete times 0; ; 2; :::k; N = T ;
his strategy is to hold k (xk ) assets if its price is x(t) = xk when the time is t = k . The change of
wealth due to this trading is simply given by:
NX1

Wtrading = k (xk )[xk+1 er xk ]er(T t ) (1)
k=0
1
For the special case where the average rate of return on the stock is the same as that of the bond, the relevant
calculations can be found in Bouchaud & Sornette (1994). In the general case the analysis is slightly more involved, but
leads to the same result Aurell & Simdyankin (1996)

3
The logic of (1) is that the writer at time k can decide to hold a portfolio of k (xk ) shares of stock, or
to convert it into xk k (xk ) of cash or bonds. At time (k +1) , in the rst case, the stock portfolio will
be worth xk+1 k (xk ), while in the second case the bond portfolio will be worth er xk k (xk ), where r
is risk-free rate. The dierence is a net prot or loss realized at time (k + 1) . When carried forwards
to time N , that is T , it gives a net prot or loss on account of k (xk )[xk+1 er xk ]er(N (k+1)) .
Summing up all contributions from all trades gives (1).
Finally, at time T , the writer looses the dierence x xc if the option is exercized. Thus the
complete wealth balance reads:
NX1

W = C [x0; xc; T ]erT max(x xc ; 0) + k (xk )xk erT r(k+1) (2)
k=0
where we have introduced the notation: xk  [xk+1 er xk ]. Note that xk is posterior to the instant
k where k is determined.
The average prot is
NX1
P <
W >= C [x0; xc; T ]erT < max(x xc ; 0) > + < k (xk ) >< xk > erT r(k+1) (3)
k=0
and the risk is q
R  < (
W )2 > (<
W >)2 (4)
We will not here write out explicitly the various terms in R, which are similar to those in (3). The
interested reader can nd them, with all necessary details, in Bouchaud & Sornette (1994) and Aurell
_
& Zyczkowski (1996). The important properties which we want to use and stress are that R is always
greater than or equal to zero and that the minimum is obtained for a denite strategy  . This will be
our optimal hedging strategy. Inserting it in (3) we get the prot using the optimal hedge, which by
our second condition on option pricing should be zero. That determines our option price prescription,
which is thus
NX1
C [x ; xc; T ] = e
0
rT < max(x xc ; 0) > < k (xk ) >< xk > e r(k+1) (5)
k=0

3 The case of zero excess average return

In this section we consider the case where the average return of the stock over the bond, hxk i, is
zero. This is not, strictly speaking, of practical relevance, as this situation should not occur exactly in
reality. We show it nevertheless for two reasons: rst the pricing in this case is much simpler, because
one of the terms in (5) vanishes, and second, it can be used as a starting point of a perturbative
calculation when the average return of the stock over the bond is non-zero, but small. This latter
case is of immediate practical interest for all short to medium term options, and is treated in the next
section.
The price of the option is given by (5), but without the last term, which is zero by assumption.
Let P (x; T jx0; 0)dx be the probability that the asset value is x at time T , knowing that it was x0 at
time 0. That yields the option price
rT hmax(x rT
Z 1
C [x ; xc; T ; m = 0] = e
0 xc ; 0)i  e dx(x xc )P (x; T jx0; 0) (6)
xc
Equation (6) is of the same form as the Black-Scholes option prescription, and agrees with Black-
Scholes when the price process described by the probability P (x; T jx0; 0)dx is a geometrical Brownian
4
motion. The reader should however keep in mind that the probability in (6) is that of the share
variations themselves, so (6) is equivalent to the Black-Scholes formula, for the geometrical Brownian
price process, only in the special case we consider in this section, that is, when hxk i is equal to zero.
In the case of a geometrical Brownian motion with arbitrary average return the extra term in (5) will
take care of the dierence between (6) and Black-Scholes.
Even though residual risk is not priced at market equilibrium in our prescription, it is clearly an
important thing to know. There may also be some merit in displaying explicit formulae for residual
risk, which can be shown to be non-zero by inspection, and we therefore now turn to the computation
of this quantity, still assuming zero excess average return. In order to proceed, we shall argue that the
price increments xk are independent random variables, which is a very good approximation on highly
liquid markets as soon as  is larger than a few tens of minutes (Arneodo et al. (1996)). Assuming
further that xk are identically distributed is in general not justied, since it is well documented now
that `ARCH' eects (time dependent volatility) must be taken into account (Engle (1982), Bollerslev
(1986), Gourieroux (1992), Potters et al (1996)). However, still for pedagogical purposes, we shall
discard
p this complication, and assume that hxk x` i = D (k; `). In this case, the risk being equal to
h
W 2i, the relevant formula is rather simple:
NX1 Z 1
h
W i = h
W i + D
2 2
0 dxP (x; t = k jx0; 0)2k (x)e2r(T t )
k=0 0

NX1 Z 1 0 0 Z 1 0
2 dx (x xc )P (x0; T jx; k) dxP (x; t = k jx0; 0)k (x) xT xt er(T t  ) (7)
k=0 xc 0

where h
W 2i0 is the unhedged (k  0) risk associated to the option. Minimal risk is obtained by
setting:
@ h
W 2i = 0 (8)
@ (x) k
for all k and x. This leads to the following explicit result for the optimal hedging strategy:
Z 1 0

 (x) =
k
1 dx0(x0 x )P (x0; T jx; t = k ) x x e r(T t  )
D c T t (9)
xc
and when we insert (9) in (7) we arrive at
NX1 Z 1
h
W i = h
W i
2 2
0 D dxP (x; t = k jx0; 0)k2(x)e r (T t  ) (10)
k=0 0

In general, the left-hand side of (10) is non-zero;

p in practice it is even quite high { for example, for
typical one-month options on liquid markets, h
W 2i represents as much as 25% of the option
price itself. As mentioned in the introduction, this accounts for the existence of the (sometimes large)
bid-ask spreads observed on option markets.
However, in the special case where P (x; tjx0; 0) is normal or log-normal, and in the limit of con-
tinuous trading, that is, when  ! 0, one can show that the residual risk h
W 2i vanishes by a
somewhat miraculous identity for Gaussian integrals (Bouchaud & Sornette (1994)). This is one more
check of the correctness and self-consistency of our approach.

4 Small non-zero average return

p the stock with respect to the bond m  hxki
Let us now consider the case where the average return of
is non zero, but small. Small here means that mN  DN (N = T= ), or, stated in words, that the
5
average return on the time scale of the option is small compared to the typical variations, which is
certainly the case for options up to a few months2. The global wealth balance then includes the extra
term which reads:
NX1 Z 1
h
W trading i=m dxP (x; t = k jx0; 0)k (x)e r(t+ ) (11)
k=0 0

The advantage of considering the case of small average return is that one can do a perturbation around
the case of zero average return, and still use the explicit optimal strategy of (9) as a rst approximation
to lowest order in m.
Compared to the case m = 0, the option price is changed both because P (x; kjx0; 0) is biased,
and because h
Wtradingi must be substracted oR from Eq. (5). It is convenient to use the Fourier
transform of the probability distribution P~ (y ) = 11 P (x; N jx0; 0) exp(ixy )dx and to expand it in a
series introducing the cumulants cn . They are dened by
1
hX cn (iy )n i;
P~ (y ) = exp (12)
n=2 n!
where c2 = ND is the variance, c4=c22 is the kurtosis, etc... Applying the cumulant expansion to the
probability distribution in Eq.(9) we obtain the optimal strategy (Bouchaud et al (1996)):
1 ( 1)n cn @ n 1 C [x; x ; T k ]:
k (x) = c1
X
c (13)
2 n=2 (n 1)! @xn 1
Observe that in the Gaussian case (cn = 0 for n > 2) only the rst term remains and gives the standard
"
Hedging" as predicted by the theory of Black and Scholes.
Inserting the optimal strategy (13) into Eq.(11) and integrating by parts one gets an expansion
of the trading term h
Wtradingi, which put into Eq.(5) gives the following result for the option price
(Bouchaud et al (1996)):
1 cn @ n P (x0; N jx ; 0)j
C [x ; xc; T ; m] = C [x ; xc; T ; m = 0] m
X 3
0 0
c n (n 1)! @x0n 3x 0 0 0
x
= c (14)
2 =3

up to corrections of order m2 . In the Gaussian case, cn = 0 for all n  3, and one thus sees explicitly
that Cm = C0, at least to rst order in m. Actually, one can show that this is true to all orders in m in
the Gaussian case, which is an alternative way to derive the result of Black and Scholes (Bouchaud et
al (1996)) 3 .
However, for even distributions with fat tails (c3 = 0 and c4 > 0), it is easy to see from the above
formula that a positive average return m > 0 increases the price of out-of-the-money options (xc > x0 ),
and decreases the price of in-the-money options (xc < x0 ). Hence, we see again explicitly that the
independence of the option price on the average return m, which is one of the most important result
of Black and Scholes, does not survive for more general models of stock uctuations.
Note nally that Eq. (14) can also be written as:
1Z
C [x ; xc; T ; m] = e
0
rT dx(x xc )P^ (x; T jx0; 0) (15)
xc
2
Typically, m = 5% annual and D = (15%)2 annual. The order of magnitude of the error made in neglecting the
second order term in m is m2 N=D ' 0:1 even for N = 1 year.
3
This result is easy to obtain if one accepts Ito's calculus, which is only valid for `quasi' Gaussian processes in the
continuum time limit

6
with an eective distribution P^ dened as:
1 n
P^(x; T jx0; 0) = P0(x; T jx0; 0) erT m cn @ P (x; N jx ; 0)
X 1

c2 n=3 (n 1)! @xn 1 0 0 (16)

Note that the integral over x of P^ is one, but P^ is not a priori positive everywhere. Distribution P^
generalizes the `risk neutral probability' usually discussed in the context of the Black-Scholes theory,
and also has the property that the excess average return (the integral of xP~ over x) is zero, as can
easily be seen by inspection from (16). In fact, one can derive formula (15) without any restriction on
m, and the eective distribution still has the properties that it has zero average excess return (Aurell
& Simdyankin (1996)).

5 Comparison with empirical data

For short term options, the simple formula (6) is sucient to obtain the price of options, provided one
has a good model for P (x; T jx0; 0). As discussed recently in Mantegna & Stanley (1995), Arneodo
et al (1996), the distribution P of elementary increments x is well modelled in terms of truncated
Levy distributions, i.e. a Levy stable distribution of index  ' 1:5 with exponentially truncated tails.
Interestingly, the value of  seems to be rather independent of the considered asset (exchange rates,
stocks, etc..). Since the increments are independent beyond a time scale  of the order of 30 minutes,
P (x; T jx0; 0) can be reconstructed by convoluting P (x) with itself N = T= times 4 . We show in
Fig. 1 some `experimental' prices for `Bund' call options of dierent maturities (all less than a month)
and strikes between January and June 1995. The Bund is a future on long term German government
bonds traded on the LIFFE in London, from which the data was obtained. The coordinate of each
point is the theoretical price given by Eq. (6) on the x axis, and the observed price on the y axis.
The probabilities P (x; T jx0; 0) were reconstructed using historical data on P (x) in the same
period. Since 30 minutes data were used, one has rather good precision on the parameters of the
`truncated' Levy distribution. The overall agreement is satisfying: the linear regression gives a slope
of 0:9993  0:0009 with a negligible intercept (0.02 base points), to be compared with a slope of one
and a zero intercept, if theory and data were in perfect agreement. One can see that the dierence
between observed prices and theoretical prices are actually on the order of the transaction costs.
The same analysis was done using Black-Scholes log-normal pricing with zero interest rate (since
futures are margin compensated) and volatility measured historically over the same period. The
resulting graph (not shown) is visually similar to that of Fig. 1, but with a somewhat larger spread
around the line of slope one. Moreover, a linear regression on the Black-Scholes data gives a slope of
1:02  0:002 and an intercept of 6 base points. The ts on the slope and the intercept are, respectively,
one and two orders of magnitude worse than in our procedure, and re ect the fact that the Black-
Scholes theory systematically misprices mainly out-of-the-money options, while working relatively
better for at-the-money and in-the-money options.
A more detailed analysis, on other time periods, however reveals that part of the theoretical
vs observed dierences seen in Fig. 1 are systematic (Potters et al (1996)), and related to the fact
that these time-series are non-stationary: volatility is actually itself time dependent, a feature also
recognized to be important by traders. We have also compared the theoretical residual risk with
the results of a Monte-Carlo simulation, where optimally hedged portfolios were generated using real
option prices. The residual risk was found to be somewhat (about 50%) larger than the one predicted
4
This is again assuming that the x are identically distributed, which is a good rst approximation { but see Potters
et al (1996).

7
theoretically, Eq. (10), which again re ects the fact that an extra source of risk comes from the
non-stationarity of the time series, the so-called `volatility risk'.

BUND Options (1995)

500
Observed market price (in base points)

400

300

200

100

0
0 100 200 300 400 500
Theoretical price (in base points)

Figure 1: `Experimental' prices for Bund call options of dierent maturities (all less than a month)
and strikes between January and June 1995. The data was obtained from the LIFFE. The coordinate
of each point is the theoretical price and the observed price. P (x; tjx0; t0 ) was reconstructed using
historical data in the same period. The dierences with Black and Scholes are actually not very large
( 2%) for this very liquid market; however they are systematic (see text), and re ect the existence of
a `volatility smile' (i.e. the need to change the volatility used in the BS formula with the strike price),
which is well captured by a truncated Levy process description.

6 Discussion
In the last twenty-ve years nancial derivatives have grown from a somewhat marginal activity to
occupy center-stage position in economical theory and practice. At the same time, mathematical
nance has grown to be one of the main branches of applied mathematics, and in even more simple
terms, a sizeable fraction of graduates in mathematics and related subjects now go on to work on
option pricing.
The single largest credit for these remarkable developments are due to Fisher Black and Myron
Scholes, who in their classic paper of 1973 gave a theory of how to price options in a simple model.
Without this prescription, option pricing would have remained more of an art than a science, and
trading in options would have arguably have been less liquid and important, as traders would have

8
had a less rm idea on how to hedge the bet on the future, which options in the end come down to
be. It is certain that without the Black-Scholes' formula, the mutual interest of mathematicians in
nance and nancial operators in advanced mathematical techniques would not have been what they
are today.
Nevertheless, like all clear-cut and useful results, the Black-Scholes theory holds only under certain
denite conditions. If these are not fullled, it is an open question whether to price an option using
the Black-Scholes formula is the best possible strategy. The economically sensible meaning of best
and better in this context must be, that a strategy is better if those operators who use it in the long
run do better than the rest.
Empirical and theoretical modications to the Black-Scholes theory amount today to a small indus-
try. We surveyed some parts of that literature in the introduction, and will not repeat that discussion
here, except to remark that the less academic side of this activity goes on in a commercial environment,
and would not prosper if there were not prot to made fram capitalizing on the short-comings of the
Black-Scholes theory. Successful nancial operators must eectively use pricing procedures at least
as good as Black-Scholes, to oset the additional costs of time and money. Those pricing procedures
are of course not made available directly to the public, but, to judge from the published literature,
they seem at least partly based on arguments which are ad hoc, or in any case dicult to penetrate.
It is therefore quite concieveable that pricing procedures on the market eectively come down to
approximations, stated in terms which can be very complicated, and perhaps not fully rationalized,
to some other prescription, which is not necessarily known by the operators themselves. A similar
situation probably pertained twenty-ve years ago before the Black-Scholes theory had been published
and become widely known.
We have in this paper presented an approach to option pricing which is almost as simple as the
Black-Scholes theory. Indeed, from the conceptual point of view it is even simpler, and can be described
entirely in elementary terms: rst a special hedging strategy is chosen such that risk (measured by
the variance) is minimized. Then the price is determined by the condition that the mean prot of an
operator using the special hedge is zero.
In theoretical terms the advantage of our prescription is that it only demands that we minimize
risk, not that we eliminate it entirely. In Black-Scholes theory, the crucial argument is the absence
of arbitrage on eective markets, which means that there can only be one risk-free rate of return.
Hence, to use these arguments, it must be possible to hedge away all risk entirely. Since risk must
always be non-negative, our prescription agrees with Black-Scholes in all cases where the latter can
be applied, but it can also be applied in a much wider setting. That a strategy is determined by
risk-minimization is intuitively appealing, and certainly very reasonable for risk-sensitive operators.
A further theoretical argument can however also be made from equilibrium considerations on a market
_
with operators with dierent attitudes to risk (Aurell & Zyczkowski, 1996).
In computational terms our prescription can be used to derive analytical formulae, of similar
complexity as those in the Black-Scholes theory. Those formulae are valid when the excess rate of
return of the stock over the bond is small compared to stock volatility. The precise meaning of small
is claried above in section 4, suce it to say that the formulae hold with good accuracy for options
with time to expiration up to a few months. Longer term options are in any case more dicult since
the assumption of stationarity of the time series becomes more and more questionable as the time to
maturity increases. The prescription can also be used directly as a specication of a minimization
problem, which could be used for options with long time to expiration. This minimization problem
can be handled with standard numerical tools.
In empirical terms, we have compared our prescription to real nancial data from the LIFFE
exchange, a very liquid market where bid-ask spreads are expected to be small, and found quite good
agreement.

9
 Let us separate the discussion of the general potential practical usefulness of our prescription into
the general idea to minimimize risk, and the concrete formulae derived above in sections 3 and 4. We
believe that the general framework we have presented, to determine prices of derivative securities by
minimizing risk, has very wide applicability. It can also be used in situations where variance is not
an adequate measure of risk, because the tail of the distribution is so massive that the variance is
formally innite (Bouchaud et al, 1996,1997). A relevant measure of risk is then the probability of
large losses, and the prescription says that the probability of these losses (or the Value-at-Risk) should
be minimized.
We have in this paper looked at the simplest implementation of the general idea of option pricing
by risk minimization. We assumed that price increments are independent, identically distributed
random variables and that there are no transaction costs, and thus derived the formulae presented in
sections 3 and 4. The direct practical usefulness of these formulae then hinges on that the assumptions
are suciently well fullled, and that the resulting price prescription is systematically dierent from
the one that can be derived from Black-Scholes, which re ects the need of operators to use a volatility
`smile'. However, an even closer agreement with market prices is obtained when one explicitely takes
into account what is known as `volatility risk' (Potters et al. (1996)).

7 Acknowledgements
We thank J.-P. Aguilar, R. Cont, and D. Sornette for important discussions. This work was supported
by the Swedish Natural Science Research Council through grant S-FO 1778-302 (E.A.), by a grant from
the Swedish Board of Research and Development NUTEK (E.A.), and by the Polish State Committee
_
for Research (K.Z.).

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