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Implied Volatility Functions: Empirical Tests

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  • Dumas, Bernard J
  • Fleming, Jeff
  • Whaley, Robert E
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    Abstract

    Black and Scholes (1973) implied volatilities tend to be systematically related to the option’s exercise price and time to expiration. Derman and Kani (1994), Dupire (1994), and Rubinstein (1994) attribute this behaviour to the fact that the Black/Scholes constant volatility assumption is violated in practice. These authors hypothesize that the volatility of the underlying asset’s return is a deterministic function of the asset price and time, and develop the deterministic volatility function (DVF) option valuation model, which has the potential of fitting the observed cross-section of option prices exactly. Using a sample of Standard and Poors index of 500 companies (S&P 500) options during the period June 1988 through December 1993, we evaluate the economic significance of the implied deterministic volatility function by examining the predictive and hedging performance of the DVF option valuation model.

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    Bibliographic Info

    Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1369.

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    Date of creation: Apr 1996
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    Handle: RePEc:cpr:ceprdp:1369

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    Related research

    Keywords: Asset Prices; Volatility;

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    Cited by:
    1. Joshua V. Rosenberg & Robert F. Engle, 1997. "Option Hedging Using Empirical Pricing Kernels," NBER Working Papers 6222, National Bureau of Economic Research, Inc.
    2. Garcia, R. & Renault, E., 1998. "Risk Aversion, Intertemporal Substitution, and Option Pricing," Cahiers de recherche 9801, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
    3. Robert Tompkins, 2001. "Implied volatility surfaces: uncovering regularities for options on financial futures," The European Journal of Finance, Taylor & Francis Journals, vol. 7(3), pages 198-230.
    4. Steven L. Heston & Saikat Nandi, 1997. "A closed-form GARCH option pricing model," Working Paper 97-9, Federal Reserve Bank of Atlanta.
    5. Zsembery, Levente, 2003. "A volatilitás előrejelzése és a visszaszámított modellek
      [Forecasting of volatility and implied models]
      ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(6), pages 519-542.
    6. Peter A. Abken & Saikat Nandi, 1996. "Options and volatility," Economic Review, Federal Reserve Bank of Atlanta, issue Dec, pages 21-35.
    7. David S. Bates, 1997. "Post-'87 Crash Fears in S&P 500 Futures Options," NBER Working Papers 5894, National Bureau of Economic Research, Inc.
    8. Rama CONT, 1998. "Beyond implied volatility: extracting information from option prices," Finance 9804002, EconWPA.
    9. Pena, Ignacio & Rubio, Gonzalo & Serna, Gregorio, 1999. "Why do we smile? On the determinants of the implied volatility function," Journal of Banking & Finance, Elsevier, vol. 23(8), pages 1151-1179, August.

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