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Regression-based modeling of market option prices: with application to S&P500 options

  • Gurupdesh S. Pandher

    (Department of Finance, DePaul University, Chicago, Illinois, USA)

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    This paper presents a simple empirical approach to modeling and forecasting market option prices using localized option regressions (LOR). LOR projects market option prices over localized regions of their state space and is robust to assumptions regarding the underlying asset dynamics (e.g. log-normality) and volatility structure. Our empirical study using 3 years of daily S&P500 options shows that LOR yields smaller out-of-sample pricing errors (e.g. 32% 1-day-out) relative to an efficient benchmark from the literature and produces option prices free of the volatility smile. In addition to being an efficient and robust option-modeling and valuation tool for large option books, LOR provides a simple-to-implement empirical benchmark for evaluating more complex risk-neutral models. Copyright © 2007 John Wiley & Sons, Ltd.

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    File URL: http://hdl.handle.net/10.1002/for.1035
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    Article provided by John Wiley & Sons, Ltd. in its journal Journal of Forecasting.

    Volume (Year): 26 (2007)
    Issue (Month): 7 ()
    Pages: 475-496

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    Handle: RePEc:jof:jforec:v:26:y:2007:i:7:p:475-496
    DOI: 10.1002/for.1035
    Contact details of provider: Web page: http://www3.interscience.wiley.com/cgi-bin/jhome/2966

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    1. Charles Quanwei Cao & Gurdip S. Bakshi & Zhiwu Chen, 1997. "Empirical Performance of Alternative Option Pricing Models," Yale School of Management Working Papers ysm65, Yale School of Management.
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    6. Hull, John C & White, Alan D, 1987. " The Pricing of Options on Assets with Stochastic Volatilities," Journal of Finance, American Finance Association, vol. 42(2), pages 281-300, June.
    7. Peter Christoffersen & Kris Jacobs, 2003. "The Importance of the Loss Function in Option Valuation," CIRANO Working Papers 2003s-52, CIRANO.
    8. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
    9. Carr, Peter & Wu, Liuren, 2004. "Time-changed Levy processes and option pricing," Journal of Financial Economics, Elsevier, vol. 71(1), pages 113-141, January.
    10. Hutchinson, James M & Lo, Andrew W & Poggio, Tomaso, 1994. " A Nonparametric Approach to Pricing and Hedging Derivative Securities via Learning Networks," Journal of Finance, American Finance Association, vol. 49(3), pages 851-89, July.
    11. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-43.
    12. Jens Carsten Jackwerth, 1998. "Recovering Risk Aversion from Option Prices and Realized Returns," Finance 9803002, EconWPA.
    13. 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.
    14. Jacquier, Eric & Jarrow, Robert, 2000. "Bayesian analysis of contingent claim model error," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 145-180.
    15. Bates, David S, 1996. "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in Deutsche Mark Options," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 69-107.
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