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GARCH option pricing: A semiparametric approach

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  • Badescu, Alexandru M.
  • Kulperger, Reg J.
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    Abstract

    Option pricing based on GARCH models is typically obtained under the assumption that the random innovations are standard normal (normal GARCH models). However, these models fail to capture the skewness and the leptokurtosis in financial data. We propose a new method to compute option prices using a nonparametric density estimator for the distribution of the driving noise. We investigate the pricing performances of this approach using two different risk neutral measures: the Esscher transform pioneered by Gerber and Shiu [Gerber, H.U., Shiu, E.S.W., 1994a. Option pricing by Esscher transforms (with discussions). Trans. Soc. Actuar. 46, 99-91], and the extended Girsanov principle introduced by Elliot and Madan [Elliot, R.J., Madan, D.G., 1998. A discrete time equivalent martingale 9 measure. Math. Finance 8, 127-152]. Both measures are justified by economic arguments and are consistent with Duan's [Duan, J.-C., 1995. The GARCH option pricing model. Math. Finance 5, 13-32] local risk neutral valuation relationship (LRNVR) for normal GARCH models. The main advantage of the two measures is that one can price derivatives using skewed or heavier tailed innovations distributions to model the returns. An empirical study regarding the European Call option valuation on S&P500 Index shows: (i) under both risk neutral measures our semiparametric algorithm performs better than the existing normal GARCH models if we allow for a leverage effect and (ii) the pricing errors when using the Esscher transform are quite small even though our estimation procedure is based only on historical return data.

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    Bibliographic Info

    Article provided by Elsevier in its journal Insurance: Mathematics and Economics.

    Volume (Year): 43 (2008)
    Issue (Month): 1 (August)
    Pages: 69-84

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    Handle: RePEc:eee:insuma:v:43:y:2008:i:1:p:69-84

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    Web page: http://www.elsevier.com/locate/inca/505554

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    References

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    Cited by:
    1. Badescu, Alex & Elliott, Robert J. & Siu, Tak Kuen, 2009. "Esscher transforms and consumption-based models," Insurance: Mathematics and Economics, Elsevier, Elsevier, vol. 45(3), pages 337-347, December.
    2. Alexandru Badescu & Robert J. Elliott & Juan-Pablo Ortega, 2012. "Quadratic hedging schemes for non-Gaussian GARCH models," Papers, arXiv.org 1209.5976, arXiv.org, revised Dec 2013.

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