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A GARCH option pricing model with filtered historical simulation


Barone-Adesi, Giovanni; Engle, Robert F; Mancini, Loriano (2008). A GARCH option pricing model with filtered historical simulation. Review of Financial Studies, 21(3):1223-1258.

Abstract

We propose a new method for pricing options based on GARCH models with filtered historical innovations. In an incomplete market framework, we allow for different distributions of historical and pricing return dynamics, which enhances the model's flexibility to fit market option prices. An extensive empirical analysis based on S&P 500 index options shows that our model outperforms other competing GARCH pricing models and ad hoc Black-Scholes models. We show that the flexible change of measure, the asymmetric GARCH volatility, and the nonparametric innovation distribution induce the accurate pricing performance of our model. Using a nonparametric approach, we obtain decreasing state-price densities per unit probability as suggested by economic theory and corroborating our GARCH pricing model. Implied volatility smiles appear to be explained by asymmetric volatility and negative skewness of filtered historical innovations.

We propose a new method for pricing options based on GARCH models with filtered historical innovations. In an incomplete market framework, we allow for different distributions of historical and pricing return dynamics, which enhances the model's flexibility to fit market option prices. An extensive empirical analysis based on S&P 500 index options shows that our model outperforms other competing GARCH pricing models and ad hoc Black-Scholes models. We show that the flexible change of measure, the asymmetric GARCH volatility, and the nonparametric innovation distribution induce the accurate pricing performance of our model. Using a nonparametric approach, we obtain decreasing state-price densities per unit probability as suggested by economic theory and corroborating our GARCH pricing model. Implied volatility smiles appear to be explained by asymmetric volatility and negative skewness of filtered historical innovations.

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55 citations in Web of Science®
74 citations in Scopus®
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Additional indexing

Item Type:Journal Article, refereed, further contribution
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:May 2008
Deposited On:23 Jan 2009 10:44
Last Modified:05 Apr 2016 12:51
Publisher:Oxford University Press
ISSN:0893-9454
Additional Information:This is a pre-copy-editing, author-produced PDF of an article accepted for publication in The Review of Financial Studies following peer review. The definitive publisher-authenticated version Review of Financial Studies 21(3):1223-1258 is available online at: dx.doi.org/10.1093/rfs/hhn031.
Publisher DOI:10.1093/rfs/hhn031
Permanent URL: http://doi.org/10.5167/uzh-10865

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