Options on a Stock with Market-Dependent VolatilityJ. Chalupa Abstract: A market is considered whose index has strongly price-dependent local volatility. A tractable parametrization of the volatility is formulated, and option valuation of a stock with two-factor dynamics is investigated. One factor is the market index; when the second factor is uncorrelated with the first, the option valuation equation can separate. A formal solution is given for a European call. The call value depends on both the stock price and the market index. Even if the prices of a set of calls were fitted with a one-factor implied volatility, the calls could not be hedged solely with an offsetting position in the stock. For example, delta-hedging involves two deltas, one corresponding to the stock and the other to the market index. In a numerical example, the magnitude of the market delta is found to be significant. The CAPM is used as an example to explore how market-dependent volatilities could be implemented in multifactor models. In the process, the Black-Scholes equation with standard boundary conditions is reduced to quadrature for squared volatilities proportional to (1+an*sm^n)/(1+ad*sm^n); sm is the market index, and n, an, and ad are constants. Keywords: equity options; implied volatility; hedging (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpfi:9710005 Access Statistics for this paper More papers in Finance from EconWPA |
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