Option pricing with discrete time jump processes

Dominique Guegan (), Florian Ielpo () and Hanjarivo Lalaharison ()
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Dominique Guegan: CES - Centre d'économie de la Sorbonne - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique
Florian Ielpo: Lombard Odier Asset Management - Lombard Odier Asset Management
Hanjarivo Lalaharison: CES - Centre d'économie de la Sorbonne - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique

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Abstract: In this paper we propose new option pricing models based on class of models with jumps contained in the Lévy-type based models (NIG-Lévy, Schoutens, 2003, Merton-jump, Merton, 1976 and Duan based model, Duan et al., 2007). By combining these different classes of models with several volatility dynamics of the GARCH type, we aim at taking into account the dynamics of financial returns in a realistic way. The associated risk neutral dynamics of the time series models is obtained through two different specifications for the pricing kernel: we provide a characterization of the change in the probability measure using the Esscher transform and the Minimal Entropy Martingale Measure. We finally assess empirically the performance of this modelling approach, using a dataset of European options based on the S&P 500 and on the CAC 40 indices. Our results show that models involving jumps and a time varying volatility provide realistic pricing and hedging results for options with different kinds of time to maturities and moneyness. These results are supportive of the idea that a realistic time series model can provide realistic option prices making the approach developed here interesting to price options when option markets are illiquid or when such markets simply do not exist.

Keywords: Option pricing; Time Jump processes; Exponential affine stochastic discount factor; Minimal Entropy Martingale Measure; S&P 500; CAC 40 (search for similar items in EconPapers)
Date: 2013-12
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Citations: View citations in EconPapers (5)

Published in Journal of Economic Dynamics and Control, 2013, 37 (12), pp.2417-2445. ⟨10.1016/j.jedc.2013.07.003⟩

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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-00964950

DOI: 10.1016/j.jedc.2013.07.003

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