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Estimation of Risk Neutral Measures using the Generalized Two-Factor Log-Stable Option Pricing Model
| Content Provider | Semantic Scholar |
|---|---|
| Author | McCulloch, J. Huston Lee, Seung Hwan |
| Copyright Year | 2008 |
| Abstract | We construct a simple representative agent model to provide a theoretical framework for the logstable option pricing model. We also implement a new parametric method for estimating the risk neutral measure (RNM) using a generalized two-factor log-stable option pricing model. Under the generalized two-factor log-stable uncertainty assumption, the RNM for the log of price is a convolution of two exponentially tilted stable distributions. Since the RNM for generalized two-factor log-stable uncertainty is expressed in terms of its Fourier Transform, we introduce a simple extension of the Fast Fourier Transform inversion procedure in order to reduce computational errors in option pricing. The generalized two-factor log-stable RNM has a very flexible parametric form for approximating other probability distributions. Thus, this model provides a sufficiently accurate tool for estimating the RNM from the observed option prices even if the log-stable assumption might not be satisfied. We estimate the RNM for the S&P 500 index options and find that the generalized two-factor log-stable model gives better performance than the Black-Scholes model, the finite moment log-stable model (Carr and Wu, 2003), and the orthogonal log-stable model (McCulloch, 2003) in fitting the observed option prices. † Economics Department, The Ohio State University, 1945 N. High St., Columbus OH 43210. Tel.: +1614-292-2070, E-mail address: lee.2409@osu.edu (S.H. Lee). The authors thank P. Evans, P.S. Lam, and R. Kimmel, and participants of the 2007 International Conference on Computing in Economics and Finance for helpful suggestions. JEL Field: C13, D81, G13. Keyword: Risk-neutral measure, option pricing, pricing kernel, stable distribution, exponentially tilted distribution, FFT. |
| File Format | PDF HTM / HTML |
| Alternate Webpage(s) | http://economics.sbs.ohio-state.edu/jhm/papers/RNM_GTLS.pdf |
| Alternate Webpage(s) | http://www.econ.ohio-state.edu/jhm/papers/RNM_GTLS.pdf |
| Language | English |
| Access Restriction | Open |
| Content Type | Text |
| Resource Type | Article |
