Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in Deutschemark Options
David S. Bates
University of Iowa - Department of Finance; National Bureau of Economic Research (NBER)
REVIEW OF FINANCIAL STUDIES, Vol. 9 No. 1
An efficient method is developed for pricing American options on stochastic volatility/jump-diffusion processes under systematic jump and volatility risk. The parameters implicit in Deutschemark options of the model and various submodels are estimated over 1984-91 via nonlinear generalized least squares, and are tested for consistency with $/DM futures prices and the implicit volatility sample path. The stochastic volatility submodel cannot explain the "volatility smile" evidence of implicit excess kurtosis, except under parameters implausible given the time series properties of implicit volatilities. Jump fears can explain the smile, and are consistent with one 8% DM appreciation "outlier" observed over 1984-91.
JEL Classification: G14Accepted Paper Series
Date posted: August 22, 1998
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