A Study Towards a Unified Approach to the Joint Estimation of Objective and Risk Neutral Measures for the Purpose of Options Valuation

Posted: 10 Feb 2001

See all articles by Mikhail Chernov

Mikhail Chernov

UCLA Anderson

Eric Ghysels

University of North Carolina Kenan-Flagler Business School; University of North Carolina (UNC) at Chapel Hill - Department of Economics

Abstract

The purpose of this paper is to bridge two strands of the literature, one pertaining to the objective or physical measure used to model an underlying asset and the other pertaining to the risk-neutral measure used to price derivatives. We propose a generic procedure using simultaneously the fundamental price and a set of option contracts. We use Heston's (1993, Review of Financial Studies 6, 327--343) model as an example, and appraise univariate and multivariate estimation of the model in terms of pricing and hedging performance. Our results, based on the S&P 500 index contract show dominance of univariate approach, which relies solely on options data. A by-product of this finding is that we uncover a remarkably simple volatility extraction filter based on a polynomial lag structure of implied volatilities. The bivariate approach, involving both the fundamental security and an option contract, appears useful when the information from the cash market reflected in the conditional kurtosis provides support to price long term.

Keyword(s): Derivative securities; Efficient method of moments; State price densities; Stochastic volatility models; Filtering

JEL Classification: G13; C14; C52; C53

Suggested Citation

Chernov, Mikhail and Ghysels, Eric, A Study Towards a Unified Approach to the Joint Estimation of Objective and Risk Neutral Measures for the Purpose of Options Valuation. Available at SSRN: https://ssrn.com/abstract=251508

Mikhail Chernov (Contact Author)

UCLA Anderson ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Eric Ghysels

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

University of North Carolina (UNC) at Chapel Hill - Department of Economics ( email )

Gardner Hall, CB 3305
Chapel Hill, NC 27599
United States
919-966-5325 (Phone)
919-966-4986 (Fax)

HOME PAGE: http://www.unc.edu/~eghysels/

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