A Practical Guide to GMM (with Applications to Option Pricing)

74 Pages Posted: 10 May 2001

See all articles by Tom Arnold

Tom Arnold

University of Richmond - E. Claiborne Robins School of Business

Timothy Falcon Crack

University of Otago - Department of Accountancy and Finance

Date Written: October 1999

Abstract

Generalized Method of Moments (GMM) is underutilized in financial economics because it is not adequately explained in the literature. We use a simple example to explain how and why GMM works. We then illustrate practical GMM implementation by estimating and testing the Black-Scholes option pricing model using S&P 500 index options data. We identify problem areas in implementation and we give practical GMM estimation advice, troubleshooting tips, and pseudo code. We pay particular attention to proper choice of moment conditions, exactly-identified versus over-identified estimation, estimation of Newey-West standard errors, and numerical optimization in the presence of multiple extrema.

Keywords: Generalized Method of Moments, GMM, Newey-West, Option Pricing, Black-Scholes

JEL Classification: A23, C13, C23, G13

Suggested Citation

Arnold, Thomas M. and Crack, Timothy Falcon, A Practical Guide to GMM (with Applications to Option Pricing) (October 1999). Available at SSRN: https://ssrn.com/abstract=268828 or http://dx.doi.org/10.2139/ssrn.268828

Thomas M. Arnold (Contact Author)

University of Richmond - E. Claiborne Robins School of Business ( email )

102 UR Drive
University of Richmond, VA 23173
United States
804-287-6399 (Phone)
804-289-8878 (Fax)

Timothy Falcon Crack

University of Otago - Department of Accountancy and Finance ( email )

Dunedin
New Zealand

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