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Realizing Smiles: Pricing Options with Realized Volatility

  • Fulvio CORSI

    (University of St. Gallen and Swiss Finance Institute)

  • Nicola FUSARI

    (University of Lugano and Swiss Finance Institute)

  • Davide LA VECCHIA

    (University of Lugano)

We develop a stochastic volatility option pricing model that exploits the informative content of historical high frequency data. Using the Two Scales Realized Volatility as a proxy for the unobservable returns volatility, we propose a simple (affine) but effective long-memory process: the Heterogeneous Auto-Regressive Gamma (HARG) model. This discrete–time process, combined with an exponential affine stochastic discount factor, leads to tractable risk-neutral dynamics. The explicit change of probability measure obtained within this framework allows the estimation of the risk-neutral parameters directly under the physical measure, leaving only one free parameter to be calibrated. An empirical analysis on S&P 500 option index shows that the proposed model outperforms competing GARCH models, being able to better capture the overall shape and dynamics of the implied volatility surface.

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File URL: http://ssrn.com/abstract=1547032
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Paper provided by Swiss Finance Institute in its series Swiss Finance Institute Research Paper Series with number 10-05.

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Length: 44 pages
Date of creation: Apr 2009
Date of revision: Jan 2010
Handle: RePEc:chf:rpseri:rp1005
Contact details of provider: Web page: http://www.SwissFinanceInstitute.ch
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