Assumptions of Normality

The assumption of normality is a common assumption in many financial models, including the Black-Scholes model. It assumes that the returns of an asset follow a normal distribution, characterized by a bell-shaped curve.

However, in reality, financial returns often deviate from normality, exhibiting features such as fat tails and skewness. The assumption of normality can lead to inaccurate pricing, underestimated risk, and suboptimal trading decisions.

Traders use alternative models that do not rely on the assumption of normality, such as those based on stable distributions or extreme value theory. Understanding the limitations of the normality assumption is crucial for accurate financial modeling and risk management.

In the cryptocurrency space, where volatility is often high and returns are non-normal, the assumption of normality is particularly problematic.