American Option Pricing using GARCH models and the Normal Inverse Gaussian distribution

40 Pages Posted: 20 Nov 2006 Last revised: 13 Nov 2007

See all articles by Lars Stentoft

Lars Stentoft

Department of Economics, University of Western Ontario; Center for Interuniversity Research and Analysis on Organization (CIRANO); Aarhus University - CREATES

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Date Written: November 12, 2007

Abstract

In this paper we propose a feasible way to price American options in a model with time varying volatility and conditional skewness and leptokurtosis using GARCH processes and the Normal Inverse Gaussian distribution. We show how the risk neutral dynamics can be obtained in this model using the Generalized Local Risk Neutral Valuation Relationship of Duan (1999) and we derive approximation procedures which allows for a feasible implementation of the model. A Monte Carlo study shows that there are important pricing differences compared to the Gaussian case. When the model is estimated the results indicate that compared to the Gaussian case the extensions are important. A large scale empirical examination confirms this finding and shows that our model outperforms the Gaussian case for pricing options on three large US stocks. In particular, improvements are found for out of the money options and short term options. These are among the most traded and the suggested model is therefore important.

Keywords: GARCH models, Normal Inverse Gaussian distribution, American Options, Least Squares Monte-Carlo

JEL Classification: C22, C53, G13

Suggested Citation

Stentoft, Lars, American Option Pricing using GARCH models and the Normal Inverse Gaussian distribution (November 12, 2007). Available at SSRN: https://ssrn.com/abstract=946002 or http://dx.doi.org/10.2139/ssrn.946002

Lars Stentoft (Contact Author)

Department of Economics, University of Western Ontario ( email )

London, Ontario N6A 5B8
Canada

Center for Interuniversity Research and Analysis on Organization (CIRANO)

2020 rue University, 25th floor
Montreal H3C 3J7, Quebec
Canada

Aarhus University - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

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