Option Pricing using Realized Volatility
AbstractIn the present paper we suggest to model Realized Volatility, an estimate of daily volatility based on high frequency data, as an Inverse Gaussian distributed variable with time varying mean, and we examine the joint properties of Realized Volatility and asset returns. We derive the appropriate dynamics to be used for option pricing purposes in this framework, and we show that our model explains some of the mispricings found when using traditional option pricing models based on interdaily data. We then show explicitly that a Generalized Autoregressive Conditional Heteroskedastic model with Normal Inverse Gaussian distributed innovations is the corresponding benchmark model when only daily data is used. Finally, we perform an empirical analysis using stock options for three large American companies, and we show that in all cases our model performs significantly better than the corresponding benchmark model estimated on return data alone. Hence the paper provides evidence on the value of using high frequency data for option pricing purposes.
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Bibliographic InfoPaper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2008-13.
Date of creation: 03 Mar 2008
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Web page: http://www.econ.au.dk/afn/
Option Pricing; Realized Volatility; Stochastic Volatility; GARCH;
Find related papers by JEL classification:
- C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models &bull Diffusion Processes
- C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-06-27 (All new papers)
- NEP-FMK-2008-06-27 (Financial Markets)
- NEP-MST-2008-06-27 (Market Microstructure)
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