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Building a Consistent Pricing Model from Observed Option Prices

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Author Info
Laurent, Jean-Paul
Dietmar P.J. Leisen
Abstract

This paper constructs a model for the evolution of a risky security that is consistent with a set of observed call option prices. It explicitly treats the fact that only a discrete data set can be observed in practice. The framework is general and allows for state dependent volatility and jumps. The theoretical properties are studied. An easy procedure to check for arbitrage opportunities in market data is proved and then used to ensure the feasibility of our approach. The implementation is discussed: testing on market data reveals a U-shaped form for the "local volatility" depending on the state and, surprisingly, a large probability for strong price movements.

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File URL: ftp://web.bgse.uni-bonn.de/pub/RePEc/bon/bonsfb/bonsfb443.pdf
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Publisher Info
Paper provided by University of Bonn, Germany in its series Discussion Paper Serie B with number 443.

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Length: pages
Date of creation: Dec 1998
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Handle: RePEc:bon:bonsfb:443

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Postal: Bonn Graduate School of Economics, University of Bonn, Adenauerallee 24 - 26, 53113 Bonn, Germany
Fax: +49 228 73 9221
Web page: http://www.bgse.uni-bonn.de/index.php?id=517

For technical questions regarding this item, or to correct its listing, contact: (Daniel Park).

Related research
Keywords: Markov Chain; no-arbitrage; cross-entropy; model risk;

Find related papers by JEL classification:
C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

  1. Hansen, Lars Peter & Jagannathan, Ravi, 1997. " Assessing Specification Errors in Stochastic Discount Factor Models," Journal of Finance, American Finance Association, vol. 52(2), pages 557-90, June. [Downloadable!] (restricted)
    Other versions:
  2. Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July. [Downloadable!] (restricted)
  3. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring. [Downloadable!] (restricted)
  4. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley. [Downloadable!]
  5. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. " Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1611-32, December. [Downloadable!] (restricted)
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This page was last updated on 2009-11-25.

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