Hansen-Scheinkman Factorization and Ross Recovery from Option Panels

75 Pages Posted: 25 May 2016 Last revised: 31 Mar 2019

See all articles by Fabio Massacci

Fabio Massacci

DISI - University of Trento

Julian M. Williams

Durham Business School

Yang Zhang

Northwestern University; Durham Business School

Date Written: May 25, 2016

Abstract

Determining the transition matrix of a discrete Markov process from sequential forecasts of smoothed density functions is an important element of many problems in decision theory and economics. Recent theoretical results have demonstrated that the Perron-Frobenius eigenfunction of a Markov risk neutral state price transition matrix has an interesting economic interpretation and could permit the extraction of physical forward pricing densities from options markets. Yet, the application to actual market prices is challenging. For instance, even at the intraday frequency, option market panels contain substantial gaps and can contain unpredictable levels of noise across strike prices and tenors. This paper derives an exact nonlinear programming framework utilizing the properties of the Drazin inverse of an irreducible matrix. Simulation and fit to actual data demonstrates the consistency and usefulness of the technique.

Keywords: Option pricing, Markov chain, Non-linear programming, Stochastic Discount Factor

JEL Classification: G12; G17; C61

Suggested Citation

Massacci, Fabio and Williams, Julian M. and Zhang, Yang, Hansen-Scheinkman Factorization and Ross Recovery from Option Panels (May 25, 2016). Available at SSRN: https://ssrn.com/abstract=2784153 or http://dx.doi.org/10.2139/ssrn.2784153

Fabio Massacci

DISI - University of Trento ( email )

Via Sommarive 9
Trento, Trento 38123
Italy

HOME PAGE: http://www.massacci.org

Julian M. Williams (Contact Author)

Durham Business School ( email )

Mill Hill Lane
Durham, Durham DH1 3LB
United Kingdom

Yang Zhang

Northwestern University ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Durham Business School ( email )

Mill Hill Lane
Durham, Durham DH1 3LB
United Kingdom

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