Option Pricing using Realized Volatility

Lars Stentoft

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: In the present paper we suggest to model Realized Volatility, an estimate of daily volatility based on high frequency data, as an Inverse Gaussian distributed variable with time varying mean, and we examine the joint properties of Realized Volatility and asset returns. We derive the appropriate dynamics to be used for option pricing purposes in this framework, and we show that our model explains some of the mispricings found when using traditional option pricing models based on interdaily data. We then show explicitly that a Generalized Autoregressive Conditional Heteroskedastic model with Normal Inverse Gaussian distributed innovations is the corresponding benchmark model when only daily data is used. Finally, we perform an empirical analysis using stock options for three large American companies, and we show that in all cases our model performs significantly better than the corresponding benchmark model estimated on return data alone. Hence the paper provides evidence on the value of using high frequency data for option pricing purposes.

Keywords: Option Pricing; Realized Volatility; Stochastic Volatility; GARCH (search for similar items in EconPapers)
JEL-codes: C22 C53 G13 (search for similar items in EconPapers)
Pages: 38
Date: 2008-03-03
New Economics Papers: this item is included in nep-fmk and nep-mst
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (30)

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Persistent link: https://EconPapers.repec.org/RePEc:aah:create:2008-13

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