Entropic Dynamics of Jump-Diffusion Option Pricing

The standard models of stock-price dynamics and option valuation rest on stochastic processes postulated at the outset; here, we lay down an entropic-inference framework that derives these processes rather than assuming them, by making explicit the information each one encodes. A symmetry comes first: markets reward returns rather than price levels, which selects the logarithm of price as the dynamical variable. The price then evolves through two channels, a continuous one carrying the constraints of continuity and directionality, and a jump channel carrying the arrival rate and the first two moments of the jump size. Because these constraints act on disjoint parts of the microstate, the channels factorize as a theorem, and the dynamics is the Merton jump-diffusion, with Geometric Brownian Motion as its no-jump limit; the log-price density obeys a Kolmogorov–Feller equation, of which the Fokker–Planck equation is the no-jump limit. The same principle, now imposing no-arbitrage through the mean log-return, selects the Esscher transform from among the many martingale measures an incomplete market admits, here derived rather than borrowed; the premium then satisfies Merton’s partial integro-differential equation, and the risk-neutral mixture of lognormals generates the implied-volatility smile, the Black–Scholes results returning when jumps vanish. What changes from one model to the next is never the inference but the information supplied to it.