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Implied Volatility Functions: Empirical Tests

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Author Info
Bernard Dumas
Jeff Fleming
Robert E. Whaley
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 behavior 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 S&P 500 index 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 DV option valuation model. We find that its performance is worse than that of an ad hoc Black-Scholes model with variable implied volatilities.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5500.

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Date of creation: Mar 1996
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Handle: RePEc:nbr:nberwo:5500

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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

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.:

  1. Whaley, Robert E., 1982. "Valuation of American call options on dividend-paying stocks : Empirical tests," Journal of Financial Economics, Elsevier, vol. 10(1), pages 29-58, March. [Downloadable!] (restricted)
  2. Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July. [Downloadable!] (restricted)
  3. Bossaerts, P. & Hillion, P., 1995. "Local Parametric Analysis of Hedging in Discrete Time," Discussion Paper 23, Tilburg University, Center for Economic Research. [Downloadable!]
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  4. Yacine Ait-Sahalia & Andrew W. Lo, 1995. "Nonparametric Estimation of State-Price Densities Implicit in Financial Asset Prices," NBER Working Papers 5351, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June. [Downloadable!] (restricted)
  6. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley. [Downloadable!]
  7. Lo, Andrew W., 1986. "Statistical tests of contingent-claims asset-pricing models : A new methodology," Journal of Financial Economics, Elsevier, vol. 17(1), pages 143-173, September. [Downloadable!] (restricted)
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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 A. Abken & Saikat Nandi, 1996. "Options and volatility," Economic Review, Federal Reserve Bank of Atlanta, issue Dec, pages 21-35. [Downloadable!]
  2. Robert G. Tompkins, 2001. "Implied volatility surfaces: uncovering regularities for options on financial futures," European Journal of Finance, Taylor and Francis Journals, vol. 7(3), pages 198-230, September. [Downloadable!] (restricted)
  3. Rama CONT, 1998. "Beyond implied volatility: extracting information from option prices," Finance 9804002, EconWPA. [Downloadable!]
  4. David S. Bates, 1997. "Post-'87 Crash Fears in S&P 500 Futures Options," NBER Working Papers 5894, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  5. René Garcia & Éric Renault, 1998. "Risk Aversion, Intertemporal Substitution, and Option Pricing," CIRANO Working Papers 98s-02, CIRANO. [Downloadable!]
    Other versions:
  6. Steven L. Heston & Saikat Nandi, 1997. "A closed-form GARCH option pricing model," Working Paper 97-9, Federal Reserve Bank of Atlanta. [Downloadable!]
  7. Joshua V. Rosenberg & Robert F. Engle, 1997. "Option Hedging Using Empirical Pricing Kernels," NBER Working Papers 6222, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
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