Risk Neutral Jump Arrival Rates Implied in Option Prices and their Models

39 Pages Posted: 5 Dec 2019 Last revised: 27 Dec 2021

See all articles by Dilip B. Madan

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business

King Wang

Morgan Stanley

Date Written: December 24, 2021

Abstract

Characteristic functions of risk neutral densities are constructed from the prices of options at a fixed maturity using well known procedures. The logarithm of these characteristic functions are shown to synthesize the Fourier transform of jump arrival tails. The formal arrival rate tails are actual arrival rates if their derivatives have an appropriate sign. The derivatives of formal arrival rate tails embedded in option prices are observed on occasion to be negative, reflecting signed jump arrival rates. Though puzzling at first we further observe that simple analytical cosine perturbations of the symmetric variance gamma Lévy density provides theoretical examples of such signed arrival rates consistent with a probability density. Additionally signed arrival rates also arise when models of signals perturbed by independent noise yield examples of characteristic functions for signal densities that are ratios of pure jump infinitely divisible characteristic functions. Such ratio characteristic functions can reflect signed arrival rates. Specific models using ratios of bilateral gamma and CGMY models are developed and calibrated to short maturity option prices. The ratio models provide significant improvements over their non-ratio counterparts. The models fall in the class of what have recently been termed to be quasi-infinitely divisible distributions.

Keywords: Limiting Distributions, Self-Decomposable Laws, Fourier Inversion, Crash Cliquet, Quasi-Infinite Divisibility.

JEL Classification: G11, G12, G13

Suggested Citation

Madan, Dilip B. and Wang, King, Risk Neutral Jump Arrival Rates Implied in Option Prices and their Models (December 24, 2021). Available at SSRN: https://ssrn.com/abstract=3489946 or http://dx.doi.org/10.2139/ssrn.3489946

Dilip B. Madan (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2127 (Phone)
301-314-9157 (Fax)

King Wang

Morgan Stanley ( email )

1585 Broadway
New York, NY 10036
United States

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