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What Type of Process Underlies Options? A Simple Robust Test

Author

Listed:
  • Peter Carr

    (Bloomberg LP and the Courant Institute, New York University)

  • Liuren Wu

    (Zicklin School of Business, Baruch College, CUNY)

Abstract

We develop a simple robust method to distinguish the presence of continuous and discontinuous components in the price of an asset underlying options. Our method examines the prices of at-the-money and out-of-the-money options as the option's time-to-maturity approaches zero. We show that these prices converge to zero at speeds that depend upon whether the underlying asset price process is purely continuous, purely discontinuous, or a combination of both. We apply the method to S&P 500 index options and find the existence of both a continuous component and a jump component in the index. Copyright 2003 by the American Finance Association.

Suggested Citation

  • Peter Carr & Liuren Wu, 2003. "What Type of Process Underlies Options? A Simple Robust Test," Journal of Finance, American Finance Association, vol. 58(6), pages 2581-2610, December.
  • Handle: RePEc:bla:jfinan:v:58:y:2003:i:6:p:2581-2610
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    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
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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