Option Pricing Using Realized Volatility

CREATES Research Paper No. 2008-13

40 Pages Posted: 23 Jun 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: March 3, 2008

Abstract

In the present paper we suggest to model Realized Volatility, an estimate of daily volatility based on high frequency data, as an Inverse Gaussian distributed variable with time varying mean, and we examine the joint properties of Realized Volatility and asset returns. We derive the appropriate dynamics to be used for option pricing purposes in this framework, and we show that our model explains some of the mispricings found when using traditional option pricing models based on interdaily data. We then show explicitly that a Generalized autoregressive Conditional Heteroskedastic model with Normal Inverse Gaussian distributed innovations is the corresponding benchmark model when only daily data is used. Finally, we perform an empirical analysis using stock options for three large American companies, and we show that in all cases our model performs significantly better than the corresponding benchmark model 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 (March 3, 2008). CREATES Research Paper No. 2008-13. Available at SSRN: https://ssrn.com/abstract=1148148 or http://dx.doi.org/10.2139/ssrn.1148148

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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