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Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in thePHLX Deutschemark Options

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  • David S. Bates
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    Abstract

    An efficient method is developed for pricing American options on combination stochastic volatility/jump-diffusion processes when jump risk and volatility risk are systematic and nondiversifiable, thereby nesting two major option pricing models. The parameters implicit in PHLX-traded Deutschemark options of the stochastic volatility/jump- diffusion model and various submodels are estimated over 1984-91, and are tested for consistency with the $/DM futures process and the implicit volatility sample path. The parameters implicit in options are found to be inconsistent with the time series properties of implicit volatilities, but qualitatively consistent with log- differenced futures prices. No economically significant implicit expectations of exchange rate jumps were found in full-sample estimation, which is consistent with the reduced leptokurtosis of $/DM weekly exchange rate changes over 1984-91 relative to earlier periods.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4596.

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    Date of creation: Dec 1993
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    Publication status: published as Review of Financial Studies, Vol. 9, no. 1 (1996): 69-107.
    Handle: RePEc:nbr:nberwo:4596

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    1. Peter Bossaerts & Pierre Hillion, 1993. "A Test Of A General Equilibrium Stock Option Pricing Model," Mathematical Finance, Wiley Blackwell, Wiley Blackwell, vol. 3(4), pages 311-347.
    2. Meese, Richard A, 1986. "Testing for Bubbles in Exchange Markets: A Case of Sparkling Rates?," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 94(2), pages 345-73, April.
    3. Baillie, Richard T & Bollerslev, Tim, 1989. "The Message in Daily Exchange Rates: A Conditional-Variance Tale," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 7(3), pages 297-305, July.
    4. Philippe Jorion, 1988. "On Jump Processes in the Foreign Exchange and Stock Markets," Review of Financial Studies, Society for Financial Studies, vol. 1(4), pages 427-445.
    5. Scott, Louis O., 1987. "Option Pricing when the Variance Changes Randomly: Theory, Estimation, and an Application," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(04), pages 419-438, December.
    6. Hsieh, David A., 1984. "Tests of rational expectations and no risk premium in forward exchange markets," Journal of International Economics, Elsevier, vol. 17(1-2), pages 173-184, August.
    7. Nelson, Daniel B., 1990. "ARCH models as diffusion approximations," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 7-38.
    8. Stein, Jeremy, 1989. " Overreactions in the Options Market," Journal of Finance, American Finance Association, vol. 44(4), pages 1011-23, September.
    9. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
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    11. Garman, Mark B. & Kohlhagen, Steven W., 1983. "Foreign currency option values," Journal of International Money and Finance, Elsevier, vol. 2(3), pages 231-237, December.
    12. Bailey, Warren & Stulz, René M., 1989. "The Pricing of Stock Index Options in a General Equilibrium Model," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 24(01), pages 1-12, March.
    13. Froot, Kenneth A & Thaler, Richard H, 1990. "Foreign Exchange," Journal of Economic Perspectives, American Economic Association, vol. 4(3), pages 179-92, Summer.
    14. Akgiray, Vedat & Booth, G Geoffrey, 1988. "Mixed Diffusion-Jump Process Modeling of Exchange Rate Movements," The Review of Economics and Statistics, MIT Press, vol. 70(4), pages 631-37, November.
    15. Melino, Angelo & Turnbull, Stuart M., 1990. "Pricing foreign currency options with stochastic volatility," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 239-265.
    16. Hull, John C & White, Alan D, 1987. " The Pricing of Options on Assets with Stochastic Volatilities," Journal of Finance, American Finance Association, vol. 42(2), pages 281-300, June.
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    Cited by:
    1. Daniel B. Nelson, 1994. "Asymptotic Filtering Theory for Multivariate ARCH Models," NBER Technical Working Papers 0162, National Bureau of Economic Research, Inc.
    2. Nelson, Daniel B., 1996. "Asymptotic filtering theory for multivariate ARCH models," Journal of Econometrics, Elsevier, vol. 71(1-2), pages 1-47.

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