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Realizing Smiles: Pricing Options with Realized Volatility

Fulvio Corsi (), Nicola Fusari and Davide LA Vecchia
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Nicola Fusari: University of Lugano and Swiss Finance Institute
Davide LA Vecchia: University of Lugano

No 10-05, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We develop a stochastic volatility option pricing model that exploits the informative content of historical high frequency data. Using the Two Scales Realized Volatility as a proxy for the unobservable returns volatility, we propose a simple (affine) but effective long-memory process: the Heterogeneous Auto-Regressive Gamma (HARG) model. This discrete–time process, combined with an exponential affine stochastic discount factor, leads to tractable risk-neutral dynamics. The explicit change of probability measure obtained within this framework allows the estimation of the risk-neutral parameters directly under the physical measure, leaving only one free parameter to be calibrated. An empirical analysis on S&P 500 option index shows that the proposed model outperforms competing GARCH models, being able to better capture the overall shape and dynamics of the implied volatility surface.

Keywords: High Frequency; Realized Volatility; Option Pricing (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Pages: 44 pages
Date: 2010-01, Revised 2010-01
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