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Pricing individual stock options using both stock and market index information

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  • Rombouts, Jeroen V.K.
  • Stentoft, Lars
  • Violante, Francesco

Abstract

When it comes to individual stock option pricing, most applications consider a univariate framework. From a theoretical point of view this is unsatisfactory as we know that the expected return of any asset is closely related to the exposure to the market risk factors. To address this, we model the evolution of the individual stock returns together with the market index returns in a flexible bivariate model in line with theory. The model parameters are estimated using both historical returns and aggregated option data from the index and the individual stocks. We assess the model performance by pricing a large set of individual stock options on 26 major US stocks over a long time period including the global financial crisis. Our results show that the losses from using a univariate formulation amounts to 11% on average when compared to our preferred bivariate specification.

Suggested Citation

  • Rombouts, Jeroen V.K. & Stentoft, Lars & Violante, Francesco, 2020. "Pricing individual stock options using both stock and market index information," Journal of Banking & Finance, Elsevier, vol. 111(C).
  • Handle: RePEc:eee:jbfina:v:111:y:2020:i:c:s0378426619303000
    DOI: 10.1016/j.jbankfin.2019.105727
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    References listed on IDEAS

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    Keywords

    American option pricing; Economic loss; Forecasting; Multivariate GARCH;

    JEL classification:

    • C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - General
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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