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Estimating expectations of shocks using option prices

Author

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  • Antonio Di Cesare

    () (Banca d'Italia)

Abstract

The jump-diffusion model introduced by Merton is used to price a cross- section of options at different dates. At any point in time, the parameters of the model are estimated by minimizing the sum of squared implied volatility errors, and their informational content is compared with the widely used Black and Scholes implied volatility, calculated on at-the-money options. While in normal conditions the parameters of Merton's model do not seem to provide any additional information, in periods of high variability of asset prices the jump-diffusion approach may help to disentangle the cases in which volatility reflects only uncertainty on economic fundamentals from those in which it is fuelled by fears of �nancial crisis.

Suggested Citation

  • Antonio Di Cesare, 2004. "Estimating expectations of shocks using option prices," Temi di discussione (Economic working papers) 506, Bank of Italy, Economic Research and International Relations Area.
  • Handle: RePEc:bdi:wptemi:td_506_04
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    File URL: http://www.bancaditalia.it/pubblicazioni/temi-discussione/2004/2004-0506/tema_506.pdf
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    More about this item

    Keywords

    jump-diffusion stochastic processes; option pricing; volatility;

    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

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