Option Pricing on Non-Recombining Implied Trees Assuming Serial Dependence of Returns

44 Pages Posted: 6 Mar 2008

See all articles by Christakis Charalambous

Christakis Charalambous

University of Cyprus - Department of Public and Business Administration

Eleni D. Constantinide

University of Cyprus

Spiros Martzoukos

University of Cyprus - Department of Public and Business Administration; George Washington University - School of Business

Date Written: March 4, 2008

Abstract

The non-recombining implied tree is calibrated taking into account serial dependence of stock returns. Effectively, the model becomes non-Markovian. Unlike typical preference-free option pricing models, a parameter related to the expected return of the underlying asset appears in our model. We calibrate the non-Markovian model using European calls on the FTSE 100 index for year 2003. Results strongly support our modelling approach. Pricing results are smooth without evidence of an over-fitting problem and the derived implied distributions are realistic. Also, results for the pricing of American call options indicate that the non-Markovian model outperforms the equivalent Markovian model and also the ad-hoc procedure of smoothing Black-Scholes implied volatilities proposed by Dumas et al. (1998).

Keywords: Volatility smile, nonlinear constrained optimization, implied non-recombining trees, calibration, serial dependence of returns

JEL Classification: C61, C63, G13, G15

Suggested Citation

Charalambous, Christakis and Constantinide, Eleni Demetris and Martzoukos, Spiros Harilaos Spiridon, Option Pricing on Non-Recombining Implied Trees Assuming Serial Dependence of Returns (March 4, 2008). Available at SSRN: https://ssrn.com/abstract=1102215 or http://dx.doi.org/10.2139/ssrn.1102215

Christakis Charalambous

University of Cyprus - Department of Public and Business Administration ( email )

75 Kallipoleos Street
P.O. Box 20537
Nicosia CY-1678
CYPRUS
00357-2-892258 (Phone)
00357-2-339063 (Fax)

Eleni Demetris Constantinide (Contact Author)

University of Cyprus ( email )

Department of Public and Business Administration
University of Cyprus, P.O. Box 20537
Nicosia, CY-1678
Cyprus
+35722892316 (Phone)
+35722892460 (Fax)

Spiros Harilaos Spiridon Martzoukos

University of Cyprus - Department of Public and Business Administration ( email )

75 Kallipoleos Street
P.O. Box 20537
Nicosia CY-1678
CYPRUS
357-2-892474 (Phone)
357-2-892460 (Fax)

George Washington University - School of Business

Washington, DC 20052
United States
202-994-5996 (Phone)
202-994-5014 (Fax)

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