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Realizing Smiles: Pricing Options with Realized Volatility

Author

Listed:
  • 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)

Abstract

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.

Suggested Citation

  • Fulvio CORSI & Nicola FUSARI & Davide LA VECCHIA, 2009. "Realizing Smiles: Pricing Options with Realized Volatility," Swiss Finance Institute Research Paper Series 10-05, Swiss Finance Institute, revised Jan 2010.
  • Handle: RePEc:chf:rpseri:rp1005
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    File URL: http://ssrn.com/abstract=1547032
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    Cited by:

    1. Fulvio Corsi & Roberto Renò, 2012. "Discrete-Time Volatility Forecasting With Persistent Leverage Effect and the Link With Continuous-Time Volatility Modeling," Journal of Business & Economic Statistics, Taylor & Francis Journals, vol. 30(3), pages 368-380, January.

    More about this item

    Keywords

    High Frequency; Realized Volatility; Option Pricing;

    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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