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The Price of a Smile: Hedging and Spanning in Option Markets

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  • Buraschi, Andrea
  • Jackwerth, Jens

Abstract

The volatility smile changed drastically around the crash of 1987, and new option pricing models have been proposed to accommodate that change. Deterministic volatility models allow for more flexible volatility surfaces but refrain from introducing additional risk factors. Thus, options are still redundant securities. Alternatively, stochastic models introduce additional risk factors, and options are then needed for spanning of the pricing kernel. We develop a statistical test based on this difference in spanning. Using daily S&P 500 index options data from 1986-95, our tests suggest that both in- and out-of-the-money options are needed for spanning. The findings are inconsistent with deterministic volatility models but are consistent with stochastic models that incorporate additional priced risk factors, such as stochastic volatility, interest rates, or jumps. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Suggested Citation

  • Buraschi, Andrea & Jackwerth, Jens, 2001. "The Price of a Smile: Hedging and Spanning in Option Markets," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 495-527.
  • Handle: RePEc:oup:rfinst:v:14:y:2001:i:2:p:495-527
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