Realizing Smiles: Options Pricing with Realized Volatility

52 Pages Posted: 3 Feb 2010 Last revised: 22 Nov 2011

See all articles by Fulvio Corsi

Fulvio Corsi

University of Pisa - Department of Economics; City University London

Nicola Fusari

Johns Hopkins University - Carey Business School; Northwestern University - Kellogg School of Management

Davide La Vecchia

University of St. Gallen - Swiss Institute of Banking and Finance

Date Written: November 17, 2011

Abstract

We develop a discrete-time stochastic volatility option pricing model, which exploits the information contained in high-frequency data. The Realized Volatility (RV) is used as a proxy of the unobservable log-returns volatility. We model its dynamics by a simple but effective (pseudo) long memory process, the Heterogeneous Auto-Regressive Gamma with Leverage (HARGL) process. Both the discrete-time specification and the use of the RV allow us to easily estimate the model using observed historical data. Assuming a standard, exponentially affine stochastic discount factor, we obtain a fully analytic change of measure. An extensive empirical analysis of S&P 500 index options illustrates that our approach significantly outperforms competing time-varying (i.e. GARCH-type) and stochastic volatility pricing models. The pricing improvement can be ascribed to: (i) the direct use of the RV, which provides a precise and fast-adapting measure of the unobserved underlying volatility; and (ii) the specification of our model, which, on the one hand, is able to accurately reproduce the volatility persistence and, on the other hand, provides the necessary smoothing of the noise present in the RV dynamics.

Keywords: High Frequency, Realized Volatility, Option Pricing

JEL Classification: C13, G12, G13

Suggested Citation

Corsi, Fulvio and Fusari, Nicola and La Vecchia, Davide, Realizing Smiles: Options Pricing with Realized Volatility (November 17, 2011). Swiss Finance Institute Research Paper No. 10-05. Available at SSRN: https://ssrn.com/abstract=1547032 or http://dx.doi.org/10.2139/ssrn.1547032

Fulvio Corsi

University of Pisa - Department of Economics ( email )

via Ridolfi 10
I-56100 Pisa, PI 56100
Italy

HOME PAGE: http://people.unipi.it/fulvio_corsi/

City University London ( email )

Northampton Square
London, EC1V OHB
United Kingdom

Nicola Fusari (Contact Author)

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Davide La Vecchia

University of St. Gallen - Swiss Institute of Banking and Finance ( email )

Rosenbergstrasse 52
St. Gallen, CH-9000
Switzerland

HOME PAGE: http://www.sbf.unisg.ch/org/sbf/web.nsf/c31e7c476ced62cec1256954003e839e/2fcd3bf5987bb1e4c125709f002

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