Informative Option Portfolios in Unscented Kalman Filter Design for Affine Jump Diffusion Models

Abstract

Option pricing models are tools for pricing and hedging derivatives. Good models are complex and the econometrician faces many design decisions when bringing them to the data. I show that strategically constructed low-dimensional filter designs outperform those that try to use all the available option data. I construct Unscented Kalman Filters around option portfolios that aggregate option data, and track changes in risk-neutral volatility and skewness. These low-dimensional filters perform equivalently to or better than standard approaches that treat full option panels. The performance advantage is greatest in empirically relevant settings: in models with strongly skewed jump components that are not driven by Brownian volatility.

Keywords: affine models, option pricing, filtering, unscented Kalman filter

JEL Classification: G13, C51, C53