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Specification Analysis of Option Pricing Models Based on Time-Changed Levy Processes

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Author Info
Jing-zhi Huang
Liuren Wu

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Abstract

This article analyzes the specifications of option pricing models based on time-changed Levy processes. We classify option pricing models based on (i) the structure of the jump component in the underlying return process, (ii) the source of stochastic volatility, and (iii) the specification of the volatility process itself. We then consider a variety of model specifications within this framework, and investigate empirically what type of jump structure best describe the underlying price movement and whether stochastic volatility comes from jump or diffusion. We find that, to capture the behavior of the S&P 500 index options, one needs to incorporate an infinite activity jump component in the underlying asset return process, and also to include stochastic volatilities from two separate sources: both the jump and the diffusion components

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Paper provided by Econometric Society in its series Econometric Society 2004 North American Winter Meetings with number 405.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nawm04:405

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Related research
Keywords: Option pricing; Levy processes; time change; jumps; diffusion; stochastic volatility;

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
F31 - International Economics - - International Finance - - - Foreign Exchange

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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.:
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Full references

Cited by:
(explanations, 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. Peter Carr & Liuren Wu, 2004. "Variance Risk Premia," Finance 0409015, EconWPA. [Downloadable!]
  2. Claudia Ribeiro & Nick Webber, 2006. "Correcting for Simulation Bias in Monte Carlo Methods to Value Exotic Options in Models Driven by Lévy Processes," Applied Mathematical Finance, Taylor and Francis Journals, vol. 13(4), pages 333-352, December. [Downloadable!] (restricted)
  3. Eva Ferreira & Mónica Gago & Angel León & Gonzalo Rubio, 2005. "An empirical comparison of the performance of alternative option pricing models," Investigaciones Economicas, Fundación SEPI, vol. 29(3), pages 483-523, September. [Downloadable!]
    Other versions:
  4. Peter Christoffersen & Redouane Elkamhi & Bruno Feunou & Kris Jacobs, . "Option Valuation with Conditional Heteroskedasticity and Non-Normality," CREATES Research Papers 2009-33, School of Economics and Management, University of Aarhus. [Downloadable!]
  5. Peter Carr & Liuren Wu, 2004. "Stochastic Skew in Currency Options," Finance 0409014, EconWPA. [Downloadable!]
    Other versions:
  6. Francisco Alonso & Roberto Blanco & Gonzalo Rubio, 2005. "Testing the forecasting performace of IBEX 35 option implied risk neutral densities," Banco de España Working Papers 0504, Banco de España. [Downloadable!]
  7. Liuren Wu, 2004. "Dampened Power Law: Reconciling the Tail Behavior of Financial Security Returns," Finance 0401001, EconWPA. [Downloadable!]
    Other versions:
  8. Peter Christoffersen & Kris Jacobs & Chayawat Ornthanalai, 2009. "Exploring Time-Varying Jump Intensities: Evidence from S&P500 Returns and Options," CIRANO Working Papers 2009s-34, CIRANO. [Downloadable!]
  9. Bertholon, H. & Monfort, A. & Pegoraro, F., 2007. "Pricing and Inference with Mixtures of Conditionally Normal Processes," Documents de Travail 188, Banque de France. [Downloadable!]
    Other versions:
  10. Peter Christoffersen & Kris Jacobs & Karim Mimouni, 2007. "Models for S&P500 Dynamics: Evidence from Realized Volatility, Daily Returns, and Option Prices," CREATES Research Papers 2007-37, School of Economics and Management, University of Aarhus. [Downloadable!]
  11. Li, Minqiang, 2008. "Price Deviations of S&P 500 Index Options from the Black-Scholes Formula Follow a Simple Pattern," MPRA Paper 11530, University Library of Munich, Germany. [Downloadable!]
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