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Stochastic dominance, stochastic volatility, and jump risk: new theory interprets old results

November 15, 2024 @ 2:00 pm - 3:00 pm CST

Speaker: Prof Stylianos Perrakis, John Molson School of Business, Concordia Univ, Montreal

Abstract: The stochastic dominance (SD) approach is applied to the valuation of index options in frictionless markets for a wide class of stochastic volatility (SV) processes. SD allows for the derivation of a unique, exponential option pricing kernel based on the physical underlying return and volatility dynamics. A lower bound and an upper bound on option prices are obtained, for a wide class of stochastic volatility jump (SVJ) processes that feature jumps in addition to diffusion. Using parameter estimates for the physical process from high-profile studies, the bounds are shown to be remarkably tight, especially for the empirically important class of short-term near-the-money options. The bounds are in many cases inconsistent with separate parameter estimates for the risk-neutral process that are extracted from observed option prices: for many option series, the risk-neutral value exceeds the SD upper bound. This inconsistency points at the possibility that the distributional shape of the risk-neutral process is mis-specified or that the parameters are estimated without properly taking the option bid-ask spread into account.

Details

Date:
November 15, 2024
Time:
2:00 pm - 3:00 pm CST
Event Categories:
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via Zoom