Multivariate Option Pricing with Time Varying Volatility and Correlations

Jeroen Rombouts and Lars Stentoft

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

Abstract: In recent years multivariate models for asset returns have received much attention, in particular this is the case for models with time varying volatility. In this paper we consider models of this class and examine their potential when it comes to option pricing. Specifically, we derive the risk neutral dynamics for a general class of multivariate heteroskedastic models, and we provide a feasible way to price options in this framework. Our framework can be used irrespective of the assumed underlying distribution and dynamics, and it nests several important special cases. We provide an application to options on the minimum of two indices. Our results show that not only is correlation important for these options but so is allowing this correlation to be dynamic. Moreover, we show that for the general model exposure to correlation risk carries an important premium, and when this is neglected option prices are estimated with errors. Finally, we show that when neglecting the non-Gaussian features of the data, option prices are also estimated with large errors.

Keywords: Multivariate risk premia; Option pricing; GARCH models (search for similar items in EconPapers)
JEL-codes: C11 C15 C22 G13 (search for similar items in EconPapers)
Pages: 38
Date: 2010-04-30
New Economics Papers: this item is included in nep-ecm and nep-ore
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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https://repec.econ.au.dk/repec/creates/rp/10/rp10_19.pdf (application/pdf)

Related works:
Journal Article: Multivariate option pricing with time varying volatility and correlations (2011)
Working Paper: Multivariate Option Pricing With Time Varying Volatility and Correlations (2010)
Working Paper: Multivariate option pricing with time varying volatility and correlations (2010)
Working Paper: Multivariate Option Pricing with Time Varying Volatility and Correlations (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:aah:create:2010-19

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