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Option prices and implied volatility dynamics under Bayesian learning

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Author Info

  • Allan Timmerman

    (University of California, San Diego)

  • Massimo Guidolin

Abstract

This paper shows that many of the empirical biases of the Black and Scholes option pricing model can be explained by Bayesian learning effects. In the context of an equilibrium model where dividend news evolve on a binominal lattice with unknown but recursively updated probabilities we derive closed-form pricing formulas for European options. Learning is found to generate asymmetric skews in the implied volatility surface and systematic patterns in the term structure of option prices. Data on S&P 500 index option prices is used to back out the parameters of the underlying learning process and to predict the evolution in the cross-section of option prices. The proposed model leads to lower out-of-sample forecast errors and smaller hedging errors than a variety of alternative option pricing models, including Black-Scholes.

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Bibliographic Info

Paper provided by Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance in its series CeNDEF Workshop Papers, January 2001 with number P3.

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Date of creation: 04 Jan 2001
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Handle: RePEc:ams:cdws01:p3

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Postal: Dept. of Economics and Econometrics, Universiteit van Amsterdam, Roetersstraat 11, NL - 1018 WB Amsterdam, The Netherlands
Phone: + 31 20 525 52 58
Fax: + 31 20 525 52 83
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Web page: http://www.fee.uva.nl/cendef/
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Cited by:
  1. Paruolo, Paolo, 2005. "Automated Inference And The Future Of Econometrics: A Comment," Econometric Theory, Cambridge University Press, vol. 21(01), pages 78-84, February.
  2. Alexander David & Pietro Veronesi, 1998. "Option Prices with Uncertain Fundamentals: Theory and Evidence on the Dynamics of Implied Volatilities," CRSP working papers 485, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  3. Sadayuki Ono, 2007. "Option Pricing under Stochastic Volatility and Trading Volume," Discussion Papers 07/05, Department of Economics, University of York.
  4. René Garcia & Eric Ghysels & Éric Renault, 2004. "The Econometrics of Option Pricing," CIRANO Working Papers 2004s-04, CIRANO.
  5. René Garcia & Richard Luger & Éric Renault, 2001. "Empirical Assessment of an Intertemporal Option Pricing Model with Latent Variables (Note : New version February 2002) / Empirical Assessment of an Intertemporal Option Pricing Model with Latent Varia," CIRANO Working Papers 2001s-02, CIRANO.

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