Parametric Inference and Dynamic State Recovery From Option Panels

Research output: Contribution to journalArticlepeer-review

54 Scopus citations

Abstract

We develop a new parametric estimation procedure for option panels observed with error. We exploit asymptotic approximations assuming an ever increasing set of option prices in the moneyness (cross-sectional) dimension, but with a fixed time span. We develop consistent estimators for the parameters and the dynamic realization of the state vector governing the option price dynamics. The estimators converge stably to a mixed-Gaussian law and we develop feasible estimators for the limiting variance. We also provide semiparametric tests for the option price dynamics based on the distance between the spot volatility extracted from the options and one constructed nonparametrically from high-frequency data on the underlying asset. Furthermore, we develop new tests for the day-by-day model fit over specific regions of the volatility surface and for the stability of the risk-neutral dynamics over time. A comprehensive Monte Carlo study indicates that the inference procedures work well in empirically realistic settings. In an empirical application to S&P 500 index options, guided by the new diagnostic tests, we extend existing asset pricing models by allowing for a flexible dynamic relation between volatility and priced jump tail risk. Importantly, we document that the priced jump tail risk typically responds in a more pronounced and persistent manner than volatility to large negative market shocks.

Original languageEnglish (US)
Pages (from-to)1081-1145
Number of pages65
JournalEconometrica
Volume83
Issue number3
DOIs
StatePublished - May 1 2015

Keywords

  • Inference
  • Jumps
  • Latent state vector
  • Option pricing
  • Risk premia
  • Specification testing
  • Stable convergence
  • Stochastic volatility

ASJC Scopus subject areas

  • Economics and Econometrics

Fingerprint

Dive into the research topics of 'Parametric Inference and Dynamic State Recovery From Option Panels'. Together they form a unique fingerprint.

Cite this