The Valuation of Reset Options When Underlying Assets are Autocorrelated
The International Journal of Business and Finance Research, Vol. 5, No. 2, pp. 95-114, 2011
20 Pages Posted: 3 Jul 2011
Date Written: 2011
This paper introduces the autocorrelation effect of assets’ returns into the valuation model of reset options. The MA(q) process, which is an extension of MA(1) process noted by Liao and Chen (2006), is applied to the valuation of reset options in this paper. Due to the impact of autocorrelation on the volatility of assets’ returns, the probability of reset and the value of reset option are affected. Positive autocorrelation increases the value of a reset option by increasing the probability of reset. On the contrary, negative autocorrelation decreases the probability of a reset and reset premium. Moreover, the reset timing is affected by the autocorrelation characteristics. In the case of positive autocorrelation, the investors tend to reset earlier to prevent a possible loss. Positive autocorrelation is also significant for the hedging of reset options. This paper demonstrates that positive autocorrelation characteristics lessens the delta jump and gamma jump problem.
Keywords: Reset Option, Autocorrelation; MA(q) process, Delta Jump; Gamma Jump
JEL Classification: G12, G13
Suggested Citation: Suggested Citation