Gama Pricing Model – Definition

Cite this article as:"Gama Pricing Model – Definition," in The Business Professor, updated July 30, 2019, last accessed August 10, 2020, https://thebusinessprofessor.com/lesson/gama-pricing-model-definition/.

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Gamma Pricing Model Definition

The gamma pricing model is a mathematics equation used to determine a European’s style options contract value of the fair market. This is more especially when there is no normal distribution with the underlying asset.

When there is an underlying asset with a long-tailed distribution or with a log-normal distribution, you can use the gamma pricing model to price option. This happens where there is movement of the dramatic market to the downside, and occurring frequently than what returns’ normal distribution would predict.

Note that gamma pricing model is one of the pricing options’ alternative. There are also other models such as trinomial tree models as well as the binomial tree.

Key Takeaways

  • The gamma pricing model is a mathematics equation used to determine a European’s style options contract value of the fair market.
  • The gamma pricing model has been developed in order to help provide accurate pricing when measuring the gamma options.

A Little More on What is the Gamma Pricing Model

When it comes to financing, the option pricing of “Black-Scholes” is one of the best. However, this pricing option does not for sure to give pricing result that is accurate under all circumstances. This is because of the assumption that the Black-Scholes model usually has a systematic distribution returns on the underlying instrument.

Because of this, there are mispricing options by the model especially to those financial instruments that do not base their trade on the normal distribution. This undervalues the downside puts.

Note that when this error happens, the investors are likely to under-hedge or over-hedge. This is especially when they decide to use this option as insurance to hedge their positions or when they want to get a clear picture of the asset’s volatility in their trading options.

Why Gamma Pricing Model is Important

The gamma pricing model has been developed in order to help provide accurate pricing in the practical world. Though there are many of these models that provide accurate pricing, gamma pricing model is specifically designed to measure the option of the gamma. The following are some of the importance of gamma pricing model:

  • It measures the delta’s rate change in the given price of an option in the underlying asset’s price.
  • Secondly, since gamma is the options’ price acceleration of the underlying asset movement, it makes investors be able to account for volatility skew’s downside which results from lack of normal distribution.
  • Also, because most people who have invested in stocks and other assets happen to hold long positions, they use this option to hedge for protection of their investment. This creates additional demand for lower purchase options compared to the higher options.
  • Lastly, the gamma price model ensures presentation that is accurate on the asset’s distribution price. This, therefore, enhances a better way of reflecting a true option with fair value.

References for “Gamma Pricing Model”

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