Parametric Inference and Dynamic State Recovery from Option Panels

Torben Andersen, Nicola Fusari () and Viktor Todorov ()
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Nicola Fusari: Northwestern University, Postal: Department of Finance, Kellogg School of Management, Evanston, IL 60208, USA
Viktor Todorov: Northwestern University, Postal: Department of Finance, Kellogg School of Management, Evanston, IL 60208, USA

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

Abstract: We develop a new parametric estimation procedure for option panels observed with error which relies on asymptotic approximations assuming an ever increasing set of observed option prices in the moneyness-maturity (cross-sectional) dimension, but with a fixed time span. We develop consistent estimators of the parameter vector and the dynamic realization of the state vector that governs the option price dynamics. The estimators converge stably to a mixed-Gaussian law and we develop feasible estimators for the limiting variance. We provide semiparametric tests for the option price dynamics based on the distance between the spot volatility extracted from the options and the one obtained nonparametrically from high-frequency data on the underlying asset. We further construct new formal tests of the model t for specific regions of the volatility surface and for the stability of the risk-neutral dynamics over a given period of time. A large-scale Monte Carlo study indicates that the inference procedures work well for empirically realistic model specifications and sample sizes. In an empirical application to S&P 500 index options we extend the popular double-jump stochastic volatility model to allow for time-varying risk premia of extreme events, i.e., jumps, as well as a more exible relation between the risk premia and the level of risk. We show that both extensions provide a significantly improved characterization, both statistically and economically, of observed option prices.

Keywords: Option Pricing; Inference; Risk Premia; Jumps; Latent State Vector; Stochastic Volatility; Specification Testing; Stable Convergence. (search for similar items in EconPapers)
JEL-codes: C51 C52 G12 (search for similar items in EconPapers)
Pages: 49
Date: 2011-05-29
New Economics Papers: this item is included in nep-ecm and nep-ets
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Related works:
Working Paper: Parametric Inference and Dynamic State Recovery from Option Panels (2012)
Working Paper: Parametric Inference and Dynamic State Recovery from Option Panels (2012)
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