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Testing option pricing models: complete and incomplete markets

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  • Olesia Verchenko

    ()
    (Kyiv School of Economics, Kyiv Economic Institute)

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    Abstract

    This paper examines the empirical performance of several complete and incomplete market models of stock price dynamics using S&P 500 options and stock market data. The main contribution of this work is that it suggests and implements an empirical approach to estimating a complete model with uncertain volatility, and then judges it against other popular option pricing processes. The performance of alternative models is evaluated from four perspectives: (1) in-sample fit to stock returns data, (2) in-sample fit to options data, (3) consistency of physical and risk-neutral parameter estimates and (4) out-of-sample option pricing. Overall, the complete model with uncertain volatility is found to .t the data much better than models with constant and price-level-dependent volatilities, and the variance gamma process, and its performance is comparable to that of a stochastic volatility model.

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    File URL: http://repec.kse.org.ua/pdf/KSE_dp38.pdf
    File Function: May 2011
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    Bibliographic Info

    Paper provided by Kyiv School of Economics in its series Discussion Papers with number 38.

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    Date of creation: Apr 2011
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    Handle: RePEc:kse:dpaper:38

    Note: Submitted to Journal of Derivatives
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    Keywords: Option pricing; complete and incomplete markets; stochastic volatility;

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    17. Elton A. Daal & Dilip B. Madan, 2005. "An Empirical Examination of the Variance-Gamma Model for Foreign Currency Options," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2121-2152, November.
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