Simulating the Evolution of the Implied Distribution

Posted: 19 Jan 2001

See all articles by George S. Skiadopoulos

George S. Skiadopoulos

University of Piraeus; Queen Mary, University of London, School of Economics and Finance

Stewart D. Hodges

University of Warwick - Financial Options Research Centre (FORC)

Abstract

Motivated by the implied stochastic volatility literature (Britten-Jones and Neuberger (1998), Derman and Kani (1997), Ledoit and Santa-Clara (1998)) this paper proposes a new and general method for constructing smile-consistent stochastic volatility models. The method is developed by recognizing that option pricing and hedging can be accomplished via the simulation of the implied risk neutral distribution. We devise an algorithm for the simulation of the implied distribution, when the first two moments change over time. The algorithm can be implemented easily, and it is based on an economic interpretation of the concept of mixture of distributions. It can also be generalized to cases where more complicated forms for the mixture are assumed. Implied Distribution, Mixture of Distributions, Simulation

Keywords: Smile-consistent stochastic volatility models,

JEL Classification: G13

Suggested Citation

Skiadopoulos, George and Hodges, Stewart D., Simulating the Evolution of the Implied Distribution. European Financial Management Journal. Available at SSRN: https://ssrn.com/abstract=250886

George Skiadopoulos (Contact Author)

University of Piraeus ( email )

80 Karaoli & Dimitriou Str.
18534 Piraeus, 185 34 -GR
Greece

HOME PAGE: http://web.xrh.unipi.gr/faculty/gskiadopoulos/

Queen Mary, University of London, School of Economics and Finance

Lincoln's Inn Fields
Mile End Rd.
London, E1 4NS
United Kingdom

Stewart D. Hodges

University of Warwick - Financial Options Research Centre (FORC) ( email )

Warwick Business School
Coventry CV4 7AL
United Kingdom
01203-523606 (Phone)

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