Can Tests Based on Option Hedging Errors Correctly Identify Volatility Risk Premia?
AbstractTests for the existence and the sign of the volatility risk premium are often based on expected option hedging errors. When the hedge is performed under the ideal conditions of continuous trading and correct model specification, the sign of the premium is the same as the sign of the mean hedging error for a large class of stochastic volatility option pricing models. We show, however, that the problems of discrete trading and model mis-specification, which are necessarily present in an empirical study, may cause the standard test to yield unreliable results. In particular, ignoring a possible jump risk premium can lead to incorrect conclusions about the volatility risk premium. We also show that delta-gamma hedges do not increase the reliability of the test compared to simple delta hedges.
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Bibliographic InfoPaper provided by Department of Finance, Goethe University Frankfurt am Main in its series Working Paper Series: Finance and Accounting with number 136.
Date of creation: 2008
Date of revision:
Stochastic Volatility; Volatility Risk Premium; Discretization Error; Model Mis-Specification;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-12-12 (All new papers)
- NEP-FIN-2004-12-12 (Finance)
- NEP-FIN-2004-12-15 (Finance)
- NEP-FMK-2004-12-12 (Financial Markets)
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