Realizing Smiles: Pricing Options with Realized Volatility
AbstractWe develop a stochastic volatility option pricing model that exploits the informative content of historical high frequency data. Using the Two Scales Realized Volatility as a proxy for the unobservable returns volatility, we propose a simple (affine) but effective long-memory process: the Heterogeneous Auto-Regressive Gamma (HARG) model. This discrete–time process, combined with an exponential affine stochastic discount factor, leads to tractable risk-neutral dynamics. The explicit change of probability measure obtained within this framework allows the estimation of the risk-neutral parameters directly under the physical measure, leaving only one free parameter to be calibrated. An empirical analysis on S&P 500 option index shows that the proposed model outperforms competing GARCH models, being able to better capture the overall shape and dynamics of the implied volatility surface.
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Bibliographic InfoPaper provided by Swiss Finance Institute in its series Swiss Finance Institute Research Paper Series with number 10-05.
Length: 44 pages
Date of creation: Apr 2009
Date of revision: Jan 2010
High Frequency; Realized Volatility; Option Pricing;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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