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The no arbitrage condition in option implied trees: evidence from the Italian index options market

Author

Listed:
  • V. Moriggia

    ()

  • S. Muzzioli

    ()

  • C. Torricelli

    ()

Abstract

A major issue in the construction of implied trees is the no arbitrage property preservation. Within the literature on deterministic smile-consistent trees using forward induction, two major contributions are: Derman and Kani (1994) and Barle and Cakici (1998). The former proposes a methodology to override the nodes that violate the no arbitrage condition. The latter extends the Derman and Kani’s algorithm, in order to increase its stability in the presence of high interest rates. The aim of the present paper is to modify the Derman and Kani’s methodology in order to improve the fit of the implied tree to option prices. The proposed methodology is compared with Barle and Cakici both in the sample and out of sample with Italian index options data. Overall findings support a better performance of the modified Derman and Kani’s methodology.

Suggested Citation

  • V. Moriggia & S. Muzzioli & C. Torricelli, 2005. "The no arbitrage condition in option implied trees: evidence from the Italian index options market," Department of Economics 0491, University of Modena and Reggio E., Faculty of Economics "Marco Biagi".
  • Handle: RePEc:mod:depeco:0491
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    Keywords

    Binomial tree; implied volatility; calibration.;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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