Estimating Expectations of Shocks Using Option Prices
26 Pages Posted: 14 Jun 2019
Date Written: July 2004
The jump-diffusion model introduced by Merton is used to price a cross-section of options at different dates. At any point in time, the parameters of the model are estimated by minimizing the sum of squared implied volatility errors, and their informational content is compared with the widely used Black and Scholes implied volatility, calculated on at-the-money options. While in normal conditions the parameters of Merton's model do not seem to provide any additional information, in periods of high variability of asset prices the jump-diffusion approach may help to disentangle the cases in which volatility reflects only uncertainty on economic fundamentals from those in which it is fuelled by fears of financial crisis.
Keywords: jump-diffusion stochastic processes, option pricing, volatility
JEL Classification: G12, G13
Suggested Citation: Suggested Citation