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A study towards a unified approach to the joint estimation of objective and risk neutral measures for the purpose of options valuation

Chernov, Mikhail and Ghysels, Eric (2000) A study towards a unified approach to the joint estimation of objective and risk neutral measures for the purpose of options valuation. Journal of Financial Economics, 56 (3). pp. 407-458. ISSN 0304-405X

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Abstract

The purpose of this paper is to bridge two strands of the literature, one pertaining to the objective or physical measure used to model an underlying asset and the other pertaining to the risk-neutral measure used to price derivatives. We propose a generic procedure using simultaneously the fundamental price, St , and a set of option contracts [(pI it )i/1,m] where m*1 and pI it is the Black}Scholes implied volatility. We use Heston's (1993. Review of Financial Studies 6, 327}343) model as an example, and appraise univariate and multivariate estimation of the model in terms of pricing and hedging performance. Our results, based on the S&P 500 index contract, show dominance of univariate approach, which relies solely on options data. A by-product of this "nding is that we uncover a remarkably simple volatility extraction "lter based on a polynomial lag structure of implied volatilities. The bivariate approach, involving both the fundamental security and an option contract, appears useful when the information from the cash market re#ected in the conditional kurtosis provides support to price long term. ( 2000 Elsevier Science S.A. All rights reserved.

Item Type: Article
Official URL: http://www.sciencedirect.com/science/journal/03044...
Additional Information: © 2000 Elsevier
Library of Congress subject classification: H Social Sciences > HB Economic Theory
H Social Sciences > HG Finance
Journal of Economic Literature Classification System: C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods: General > C14 - Semiparametric and Nonparametric Methods
C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C52 - Model Evaluation and Selection
C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C53 - Forecasting and Other Model Applications
G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing; Futures Pricing
Sets: Departments > Finance
Collections > Economists Online
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Date Deposited: 10 Nov 2011 10:36
URL: http://eprints.lse.ac.uk/39399/

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