Pricing and hedging basket options with exact moment matching

Theoretical models applied to option pricing should take into account the empirical characteristics of financial time series. In this paper, we show how to price basket options when the underlying asset prices follow a displaced log-normal process with jumps, capable of accommodating negative skewness and excess kurtosis. Our technique involves Hermite polynomial expansion that can match exactly the first mm moments of the model-implied basket return. This method is shown to provide superior results for basket options not only with respect to pricing but also for hedging.