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Model-based pricing for financial derivatives

Listed author(s):
  • Zhu, Ke
  • Ling, Shiqing
Registered author(s):

Assume that St is a stock price process and Bt is a bond price process with a constant continuously compounded risk-free interest rate, where both are defined on an appropriate probability space P. Let yt=log(St/St−1). yt can be generally decomposed into a conditional mean plus a noise with volatility components, but the discounted St is not a martingale under P. Under a general framework, we obtain a risk-neutralized measure Q under which the discounted St is a martingale in this paper. Using this measure, we show how to derive the risk neutralized price for the derivatives. Special examples, such as NGARCH, EGARCH and GJR pricing models, are given. Simulation study reveals that these pricing models can capture the “volatility skew” of implied volatilities in the European option. A small application highlights the importance of our model-based pricing procedure.

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File URL: http://www.sciencedirect.com/science/article/pii/S030440761500055X
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Article provided by Elsevier in its journal Journal of Econometrics.

Volume (Year): 187 (2015)
Issue (Month): 2 ()
Pages: 447-457

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Handle: RePEc:eee:econom:v:187:y:2015:i:2:p:447-457
DOI: 10.1016/j.jeconom.2015.02.030
Contact details of provider: Web page: http://www.elsevier.com/locate/jeconom

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