Testing alternative measure changes in nonparametric pricing and hedging of European options

Alcock, Jamie and Smith, Godfrey (2014) Testing alternative measure changes in nonparametric pricing and hedging of European options. Journal of Futures Markets, 34 4: 320-345. doi:10.1002/fut.21602

Author Alcock, Jamie
Smith, Godfrey
Title Testing alternative measure changes in nonparametric pricing and hedging of European options
Journal name Journal of Futures Markets   Check publisher's open access policy
ISSN 0270-7314
Publication date 2014-04-01
Year available 2013
Sub-type Article (original research)
DOI 10.1002/fut.21602
Open Access Status Not yet assessed
Volume 34
Issue 4
Start page 320
End page 345
Total pages 26
Place of publication Hoboken, NJ, United States
Publisher John Wiley & Sons
Language eng
Abstract Haley and Walker [Haley, M.R., & Walker, T. (2010). Journal of Futures Markets, 30, 983-1006] present the Euclidean and Empirical Likelihood nonparametric option pricing models as alternative tilts to Stutzer's [Stutzer, M. (1996). Journal of Finance, 51, 1633-1652] Canonical pricing method. We empirically test the comparative strengths of each of these methods using a large sample of traded options on the S&P100 Index. Furthermore, we explore an additional tilt based on Pearson's chi-square, and derive and empirically test nonparametric delta hedges for each of these approaches. Differences in the pricing performance of the various tilts are a function of differences between the sample distribution and the real distribution of the underlying. When the sample distribution displays fatter (thinner) tails and/or higher (lower) volatility than the true distribution, the Euclidean (Pearson's chi-square) model outperforms. Significantly, when these nonparametric methods utilize information contained in a small number of observed option prices they often outperform the implied volatility Black and Scholes [Black, F., & Scholes, M. (1973). Journal of Political Economy, 81, 637-654] model. These pricing performance differences do not translate into static and dynamic hedging performance differences. However, each of the nonparametric models induce an implied volatility smile and term structure that generally agree in form with the smile and term structure embedded in market prices.
Q-Index Code C1
Q-Index Status Confirmed Code
Institutional Status UQ

Document type: Journal Article
Sub-type: Article (original research)
Collections: School of Mathematics and Physics
Official 2014 Collection
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