How Does Duration Between Trades of Underlying Securities Affect Option Prices
AbstractWe propose a model for stock price dynamics that explicitly incorporates random waiting times between trades, also known as duration, and show how option prices can be calculated using this model. We use ultra-high-frequency data for blue-chip companies to motivate a particular choice of waiting-time distribution and then calibrate risk-neutral parameters from options data. We also show that the convexity commonly observed in implied volatilities may be explained by the presence of duration between trades. Furthermore, we find that, ceteris paribus, implied volatility decreases in the presence of longer durations, a result consistent with the findings of Engle (2000) and Dufour and Engle (2000) which demonstrates the relationship between levels of activity and volatility for stock prices.
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Bibliographic InfoPaper provided by Birkbeck, Department of Economics, Mathematics & Statistics in its series Birkbeck Working Papers in Economics and Finance with number 0721.
Date of creation: Dec 2007
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This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-12-15 (All new papers)
- NEP-MST-2007-12-15 (Market Microstructure)
- NEP-RMG-2007-12-15 (Risk Management)
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