The Price of a Smile: Hedging and Spanning in Option Markets

Posted: 17 Mar 2001

See all articles by Andrea Buraschi

Andrea Buraschi

Imperial College Business School; Centre for Economic Policy Research (CEPR)

Jens Carsten Jackwerth

University of Konstanz - Department of Economics

Abstract

The volatility smile changed drastically around the crash of 1987 and new option pricing models have been proposed in order to accommodate that change. Deterministic volatility models allow for more flexible volatility surfaces but refrain from introducing additional risk-factors. Thus, options are still redundant securities. Alternatively, stochastic models introduce additional risk-factors and options are then needed for spanning of the pricing kernel. We develop a statistical test based on this difference in spanning. Using daily S&P500 index options data from 1986-1995, our tests suggest that both in- and out-of-the-money options are needed for spanning. The findings are inconsistent with deterministic volatility models but are consistent with stochastic models which incorporate additional priced risk-factors such as stochastic volatility, interest rates, or jumps.

Suggested Citation

Buraschi, Andrea and Jackwerth, Jens Carsten, The Price of a Smile: Hedging and Spanning in Option Markets. Review of Financial Studies, Vol. 14, No. 2. Available at SSRN: https://ssrn.com/abstract=250546

Andrea Buraschi (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.andreaburaschi.com/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Jens Carsten Jackwerth

University of Konstanz - Department of Economics ( email )

Universitaetsstr. 10
Konstanz, 78457
Germany
+497531882196 (Phone)
+497531883120 (Fax)

HOME PAGE: http://cms.uni-konstanz.de/wiwi/jackwerth/

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