Option Valuation with Observable Volatility and Jump Dynamics

53 Pages Posted: 12 Sep 2014 Last revised: 20 May 2016

See all articles by Peter Christoffersen

Peter Christoffersen

University of Toronto - Rotman School of Management; Copenhagen Business School; Aarhus University - CREATES

Bruno Feunou

Bank of Canada

Yoontae Jeon

McMaster University - Michael G. DeGroote School of Business

Date Written: May 13, 2016

Abstract

Under very general conditions, the total quadratic variation of a jump-diffusion process can be decomposed into diffusive volatility and squared jump variation. We use this result to develop a new option valuation model in which the underlying asset price exhibits volatility and jump intensity dynamics. The volatility and jump intensity dynamics in the model are directly driven by model-free empirical measures of diffusive volatility and jump variation. Because the empirical measures are observed in discrete intervals, our option valuation model is cast in discrete time, allowing for straightforward filtering and estimation of the model. Our model belongs to the affine class enabling us to derive the conditional characteristic function so that option values can be computed rapidly without simulation. When estimated on S&P500 index options and returns the new model performs well compared with standard benchmarks.

Keywords: Dynamic volatility, dynamic jumps, realized volatility, realized jumps

JEL Classification: G12

Suggested Citation

Christoffersen, Peter and Feunou, Bruno and Jeon, Yoontae, Option Valuation with Observable Volatility and Jump Dynamics (May 13, 2016). Rotman School of Management Working Paper No. 2494379, Available at SSRN: https://ssrn.com/abstract=2494379 or http://dx.doi.org/10.2139/ssrn.2494379

Peter Christoffersen (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5P 3C4
Canada
416-946-5511 (Phone)

Copenhagen Business School

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

Aarhus University - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Bruno Feunou

Bank of Canada ( email )

234 Wellington Street
Ottawa, Ontario K1A 0G9
Canada
613-782-8302 (Phone)

HOME PAGE: http://sites.google.com/view/bruno-feunou/home

Yoontae Jeon

McMaster University - Michael G. DeGroote School of Business ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada

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