Option prices and implied volatility dynamics under Bayesian learning
AbstractThis 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 InfoPaper provided by Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance in its series CeNDEF Workshop Papers, January 2001 with number P3.
Date of creation: 04 Jan 2001
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- 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.
- Sadayuki Ono, 2007. "Option Pricing under Stochastic Volatility and Trading Volume," Discussion Papers 07/05, Department of Economics, University of York.
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