Advanced Search
MyIDEAS: Login

Pricing and Hedging Long-Term Options

Contents:

Author Info

  • Charles Quanwei Cao

    () (Department of Finance)

  • Gurdip S. Bakshi

    () (University of Maryland, Robert H. Smith School of Business)

  • Zhiwu Chen

    () (International Center for Finance)

Registered author(s):

    Abstract

    Recent empirical studies find that once an option pricing model has incorporated stochastic volatility, allowing interest rates to be stochastic does not improve pricing or hedging any further while adding random jumps to the modeling framework only helps the pricing of extremely short-term options but not the hedging performance. Given that only options of relatively short terms are used in existing studies, this paper addresses two related questions: Do long-term options contain different information than short-term options? If so, can long-term options better differentiate among alternative models? Our inquiry starts by first demonstrating analytically that differences among alternative models usually do not surface when applied to short term options, but do so when applied to long-term contracts. For instance, within a wide parameter range, the Arrow-Debreu state price densities implicit in different stochastic-volatility models coincide almost everywhere at the short horizon, but diverge at the long horizon. Using regular options (of less than a year to expiration) and LEAPS, both written on the S&P 500 index, we find that short- and long-term contracts indeed contain different information and impose distinct hurdles on any candidate option pricing model. While the data suggest that it is not as important to model stochastic interest rates or random jumps (beyond stochastic volatility) for pricing LEAPS, incorporating stochastic interest rates can nonetheless enhance hedging performance in certain cases involving long-term contracts.

    Download Info

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
    File URL: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=84250
    Download Restriction: no

    Bibliographic Info

    Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm90.

    as in new window
    Length:
    Date of creation: 06 May 1998
    Date of revision:
    Handle: RePEc:ysm:somwrk:ysm90

    Contact details of provider:
    Web page: http://icf.som.yale.edu/
    More information through EDIRC

    Related research

    Keywords:

    Find related papers by JEL classification:

    References

    No references listed on IDEAS
    You can help add them by filling out this form.

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as in new window

    Cited by:
    1. Robert M. Gillenkirch & Matthias M. Schabel, 1999. "Die Bedeutung der Periodenerfolgsrechnung für die Investitionssteuerung. Der Fall ungleicher Zeitpräferenzen," Working Paper Series: Finance and Accounting 36, Department of Finance, Goethe University Frankfurt am Main.
    2. Bollerslev, Tim & Ole Mikkelsen, Hans, 1999. "Long-term equity anticipation securities and stock market volatility dynamics," Journal of Econometrics, Elsevier, vol. 92(1), pages 75-99, September.
    3. L. Ingber & J.K. Wilson, 1999. "Volatility of volatility of financial markets," Lester Ingber Papers 99vv, Lester Ingber.
    4. L. Ingber, 1999. "A simple options training model," Lester Ingber Papers 99so, Lester Ingber.

    Lists

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    Statistics

    Access and download statistics

    Corrections

    When requesting a correction, please mention this item's handle: RePEc:ysm:somwrk:ysm90

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ().

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.