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Local Volatility Function Models under a Benchmark Approach

This paper studies a class of one-factor local volatility function models for stock indices under a benckmark approach. It assumes that the dynamics for a large diversified index approximates that of the growth optimal portfolio. The pricing and hedging of derivatives under the benchmark approach does not require the existence of an equivalent risk neutral martingale measure. Fair prices for index derivatives when expressed in units of the index are martingales under the real world probability measure. The real world transitin densities for the index and the underlying local volatility function can be determined from a continuum of European call option prices. As specific examples a modification of the constant elasticity of variance model and a version of the minimal market model are discussed together with a smoothed local volatility function that fits a snapshot of S&P500 index options data.

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File URL: http://www.business.uts.edu.au/qfrc/research/research_papers/rp124.pdf
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 124.

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Length: 19
Date of creation: 01 Apr 2004
Date of revision:
Handle: RePEc:uts:rpaper:124
Contact details of provider: Postal: PO Box 123, Broadway, NSW 2007, Australia
Phone: +61 2 9514 7777
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Web page: http://www.qfrc.uts.edu.au/

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  1. David Heath & Eckhard Platen, 2002. "Consistent pricing and hedging for a modified constant elasticity of variance model," Quantitative Finance, Taylor & Francis Journals, vol. 2(6), pages 459-467.
  2. David Heath & Eckhard Platen, 2002. "A variance reduction technique based on integral representations," Quantitative Finance, Taylor & Francis Journals, vol. 2(5), pages 362-369.
  3. Rama Cont & Jose da Fonseca, 2002. "Dynamics of implied volatility surfaces," Quantitative Finance, Taylor & Francis Journals, vol. 2(1), pages 45-60.
  4. Kevin Fergusson & Eckhard Platen, 2005. "On the Distributional Characterization of Log-returns of a World Stock Index," Research Paper Series 153, Quantitative Finance Research Centre, University of Technology, Sydney.
  5. H. Berestycki & J. Busca & I. Florent, 2002. "Asymptotics and calibration of local volatility models," Quantitative Finance, Taylor & Francis Journals, vol. 2(1), pages 61-69.
  6. Lishang Jiang & Qihong Chen & Lijun Wang & Jin Zhang, 2003. "A new well-posed algorithm to recover implied local volatility," Quantitative Finance, Taylor & Francis Journals, vol. 3(6), pages 451-457.
  7. Eckhard Platen, 2003. "Modeling the Volatility and Expected Value of a Diversified World Index," Research Paper Series 103, Quantitative Finance Research Centre, University of Technology, Sydney.
  8. Long, John Jr., 1990. "The numeraire portfolio," Journal of Financial Economics, Elsevier, vol. 26(1), pages 29-69, July.
  9. David Heath & Eckhard Platen, 2003. "Pricing of index options under a minimal market model with log-normal scaling," Quantitative Finance, Taylor & Francis Journals, vol. 3(6), pages 442-450.
  10. Schroder, Mark Douglas, 1989. " Computing the Constant Elasticity of Variance Option Pricing Formula," Journal of Finance, American Finance Association, vol. 44(1), pages 211-19, March.
  11. Hardy Hulley & Shane Miller & Eckhard Platen, 2005. "Benchmarking and Fair Pricing Applied to Two Market Models," Research Paper Series 155, Quantitative Finance Research Centre, University of Technology, Sydney.
  12. Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
  13. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  14. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley.
  15. Leif Andersen & Jesper Andreasen, 2000. "Volatility skews and extensions of the Libor market model," Applied Mathematical Finance, Taylor & Francis Journals, vol. 7(1), pages 1-32.
  16. Beckers, Stan, 1980. " The Constant Elasticity of Variance Model and Its Implications for Option Pricing," Journal of Finance, American Finance Association, vol. 35(3), pages 661-73, June.
  17. Platen, Eckhard, 2000. "A minimal financial market model," SFB 373 Discussion Papers 2000,91, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
  18. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-51, October.
  19. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
  20. Eckhard Platen, 2001. "Arbitrage in Continuous Complete Markets," Research Paper Series 72, Quantitative Finance Research Centre, University of Technology, Sydney.
  21. Eckhard Platen, 2002. "Benchmark Model with Intensity Based Jumps," Research Paper Series 81, Quantitative Finance Research Centre, University of Technology, Sydney.
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