Option Pricing Using Realized Volatility

CREATES Research Paper 2008-13

EFA 2008 Athens Meetings Paper

38 Pages Posted: 23 Jan 2008

See all articles by Lars Stentoft

Lars Stentoft

Department of Economics, University of Western Ontario; Center for Interuniversity Research and Analysis on Organization (CIRANO); Aarhus University - CREATES

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Date Written: May 2008

Abstract

Estimation of the volatility process of asset returns is of paramount importance in many financial applications particularly when the ultimate objective is the pricing of derivatives. Recently the use of high-frequency intraday data for estimating daily volatilities has received extensive attention with very promising results when compared to using lower frequency interday data. In the present paper we suggest to model one such measure, the Realized Volatility, as an Inverse Gaussian distributed variable with time varying mean. We derive the appropriate model to be used for option pricing purposes, and we show that it can explain some of the mispricings often found when using traditional option pricing models using interdaily data only. We then perform an empirical analysis using options on three large American stocks, and we show that in all cases the suggested model performs significantly better than models which are estimated on return data alone. Hence the paper provides evidence on the value of using high frequency data for option pricing purposes.

Keywords: Option Pricing, Realized Volatility, Stochastic Volatility, GARCH

JEL Classification: C22, C53, G13

Suggested Citation

Stentoft, Lars, Option Pricing Using Realized Volatility (May 2008). CREATES Research Paper 2008-13; EFA 2008 Athens Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1086226 or http://dx.doi.org/10.2139/ssrn.1086226

Lars Stentoft (Contact Author)

Department of Economics, University of Western Ontario ( email )

London, Ontario N6A 5B8
Canada

Center for Interuniversity Research and Analysis on Organization (CIRANO)

2020 rue University, 25th floor
Montreal H3C 3J7, Quebec
Canada

Aarhus University - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

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