Smile from the Past: A general option pricing framework with multiple volatility and leverage components

Majewski, A. A., Bormetti, G. & Corsi, F. (2013). Smile from the Past: A general option pricing framework with multiple volatility and leverage components (Report No. 13/11). London, UK: Department of Economics, City University London.

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Abstract

In the current literature, the analytical tractability of discrete time option pricing models is guarantee only for rather specific type of models and pricing kernels. We propose a very general and fully analytical option pricing framework encompassing a wide class of discrete time models featuring multiple components structure in both volatility and leverage and a flexible pricing kernel with multiple risk premia. Although the proposed framework is general enough to include either GARCH-type volatility, Realized Volatility or a combination of the two, in this paper we focus on realized volatility option pricing models by extending the Heterogeneous Autoregressive Gamma (HARG) model of Corsi et al. (2012) to incorporate heterogeneous leverage structures with multiple components, while preserving closed-form solutions for option prices. Applying our analytically tractable asymmetric HARG model to a large sample of S&P 500 index options, we evidence its superior ability to price out-of-the-money options compared to existing benchmarks.

Item Type: Monograph (Discussion Paper)
Additional Information: © 2013 the authors.
Subjects: H Social Sciences > HG Finance
Divisions: School of Social Sciences > Department of Economics > Department of Economics Discussion Paper Series
URI: http://openaccess.city.ac.uk/id/eprint/2925

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