Impact of Truncation on Model-Free Implied Moment Estimator

45 Pages Posted: 25 Aug 2014 Last revised: 1 Sep 2015

See all articles by Geul Lee

Geul Lee

Coinplug, Inc.

Li Yang

UNSW Australia Business School, School of Banking and Finance; Financial Research Network (FIRN)

Date Written: August 31, 2015

Abstract

This study examines the impact of truncation, i.e., the unavailability of extremely deep-out-of-the-money option quotes, on the model-free implied moment estimators of Bakshi et al. (2003) and suggests how truncation should be controlled for implied higher moment estimation. We show that truncation has a significantly larger impact on the implied skewness and kurtosis estimators than on the implied volatility estimator and that the impact is not completely removed by linear extrapolation (LE) suggested by Jiang and Tian (2005) or domain symmetrization (DSym) proposed by Dennis and Mayhew (2002). As an alternative method, we suggest domain stabilization (DStab) which makes the truncation error less volatile.

Keywords: Truncation error; Model-free implied moment estimators; Domain stabilization

JEL Classification: C14, C58, G13

Suggested Citation

Lee, Geul and Yang, Li, Impact of Truncation on Model-Free Implied Moment Estimator (August 31, 2015). 2015 Financial Markets & Corporate Governance Conference, Asian Finance Association (AsianFA) 2015 Conference Paper, Available at SSRN: https://ssrn.com/abstract=2485513 or http://dx.doi.org/10.2139/ssrn.2485513

Geul Lee

Coinplug, Inc. ( email )

11F, Office H, 20, Pangyoyeok-ro 146beon-gil,
Bundang-gu
Seongnam-si, Gyeonggi-do
Korea, Republic of (South Korea)

Li Yang (Contact Author)

UNSW Australia Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia
+610293855857 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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