Model-based pricing for financial derivatives

Ke Zhu () and Shiqing Ling

Journal of Econometrics, 2015, vol. 187, issue 2, 447-457

Abstract: Assume that St is a stock price process and Bt is a bond price process with a constant continuously compounded risk-free interest rate, where both are defined on an appropriate probability space P. Let yt=log(St/St−1). yt can be generally decomposed into a conditional mean plus a noise with volatility components, but the discounted St is not a martingale under P. Under a general framework, we obtain a risk-neutralized measure Q under which the discounted St is a martingale in this paper. Using this measure, we show how to derive the risk neutralized price for the derivatives. Special examples, such as NGARCH, EGARCH and GJR pricing models, are given. Simulation study reveals that these pricing models can capture the “volatility skew” of implied volatilities in the European option. A small application highlights the importance of our model-based pricing procedure.

Keywords: NGARCH; EGARCH and GJR models; Non-normal innovation; Option valuation; Risk neutralized measure; Volatility skew (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (9)

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Working Paper: Model-based pricing for financial derivatives (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:econom:v:187:y:2015:i:2:p:447-457

DOI: 10.1016/j.jeconom.2015.02.030

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