Approximating equity volatility

Ahmed Loulit ()

No 04-028.RS, Working Papers CEB from ULB -- Universite Libre de Bruxelles

Abstract: The volatility estimation is a crucial problem for pricing derivatives. The traditional implied volatility approach induces the undesired smile effect and is therefore inconsistent with the market reality. A second more realistic approach is due to Bensoussan, Crouhy and Galai (1995) who derive an extension of the Black-Scholes model where the stochastic volatility ?is endogenous and depends on the change in the firm’s financial leverage. These authors give an analytic approximation for ?when the firm is financed by external funds such as debts, under the assumptions that the risk-free rate and the volatility of the return on the firm’s asset are constant. In this work, we will generalize this result by allowing these parameters to be variable.

Keywords: Black-Scholes model; derivative pricing; volatility. (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Pages: 18 p.
Date: 2004
New Economics Papers: this item is included in nep-fin and nep-fmk
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