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Option Pricing Via Maximization Over Uncertainty And Correction Of Volatility Smile

Author

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  • NIKOLAI DOKUCHAEV

    (Department of Mathematics & Statistics, Curtin University, GPO Box U1987, Perth, 6845, Western Australia, Australia)

Abstract

The paper presents a pricing rule for market models with stochastic volatility and with an uncertainty in its evolution law. It is shown that the most common stochastic volatility models allow a possibility that the option price calculated for random volatility with an error in volatility forecasts is lower than the price for the market with zero error of volatility forecast. To eliminate this possibility, we suggest a pricing rule based on maximization of the price via a class of possible equivalent risk-neutral measures. It shown that, in a Markovian setting, this pricing rule requires to solve a parabolic Bellman equation. Some existence results and a priory estimates are obtained for this equation.

Suggested Citation

  • Nikolai Dokuchaev, 2011. "Option Pricing Via Maximization Over Uncertainty And Correction Of Volatility Smile," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 14(04), pages 507-524.
    • Handle: RePEc:wsi:ijtafx:v:14:y:2011:i:04:n:s0219024911006711
    DOI: 10.1142/S0219024911006711
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    References listed on IDEAS

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    1. René Garcia & Eric Ghysels & Eric Renault, 2004. "The Econometrics of Option Pricing," CIRANO Working Papers 2004s-04, CIRANO.
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    Cited by:

    1. Nikolai Dokuchaev, 2018. "On the implied market price of risk under the stochastic numéraire," Annals of Finance, Springer, vol. 14(2), pages 223-251, May.
    2. Nikolai Dokuchaev, 2011. "On martingale measures and pricing for continuous bond-stock market with stochastic bond," Papers 1108.0719, arXiv.org, revised Sep 2014.

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