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Pricing with finite dimensional dependence

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  • Gourieroux, C.
  • Monfort, A.

Abstract

We consider derivative pricing in factor models, where the factor is Markov with Finite Dimensional Dependence (FDD). The FDD condition allows for explicit formulas for derivative prices and their term structure and in this respect is a serious competitor of models with affine dynamic factors. The approach is illustrated by a comparison of the prices of realized and integrated volatility swaps. We show that the usual practice of replacing a payoff written on the realized volatility by the payoff written on the integrated volatility can imply pricing errors which are not negligible when the volatility of the volatility is large.

Suggested Citation

  • Gourieroux, C. & Monfort, A., 2015. "Pricing with finite dimensional dependence," Journal of Econometrics, Elsevier, vol. 187(2), pages 408-417.
    • Handle: RePEc:eee:econom:v:187:y:2015:i:2:p:408-417
    DOI: 10.1016/j.jeconom.2015.02.027
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    References listed on IDEAS

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    Cited by:

    1. Yang Lu, 2020. "A simple parameter‐driven binary time series model," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 39(2), pages 187-199, March.
    2. Chang, Chia-Lin & McAleer, Michael, 2015. "Econometric analysis of financial derivatives: An overview," Journal of Econometrics, Elsevier, vol. 187(2), pages 403-407.
    3. Chang, C-L. & McAleer, M.J., 2014. "Econometric Analysis of Financial Derivatives," Econometric Institute Research Papers EI 2015-02, Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute.

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