39 Pages Posted: 16 Aug 2015 Last revised: 13 Dec 2016
Date Written: September 1, 2016
This paper provides a novel methodology for estimating option pricing models based on risk-neutral moments. We synthesize the distribution extracted from the term structure of option prices and exploit linear relationships between risk-neutral moments and latent factors within the continuous time affine stochastic volatility framework. We find that fitting option valuation models to risk-neutral moments (variance, skewness, and kurtosis) captures a sizable fraction of the information in option prices. The information loss from option prices to risk-neutral moments is more pronounced in the left tail of the distribution. The procedure also offers guidance on the components of stochastic volatility models that allow a replication of the salient features observed in the term structure of risk-neutral moments. From a practical perspective, employing risk-neutral moments instead of option prices also helps circumvent the challenge inherent in working with a large set of option contracts.
Keywords: Risk-neutral moments, Affine term structure, Stochastic volatility models, Latent factors
JEL Classification: G12
Suggested Citation: Suggested Citation
Feunou, Bruno and Okou, Cedric, Affine Term Structure of Risk-Neutral Moments Models (September 1, 2016). Available at SSRN: https://ssrn.com/abstract=2644635 or http://dx.doi.org/10.2139/ssrn.2644635