Working Paper: NBER ID: w4519
Authors: Robert F. Engle; Alex Kane; Jaesun Noh
Abstract: In pricing primary-market options and in making secondary markets, financial intermediaries depend on the quality of forecasts of the variance of the underlying assets. Hence, the gain from improved pricing of options would be a measure of the value of a forecast of underlying asset returns. NYSE index returns over the period of 1968-1991 are used to suggest that pricing index options of up to 90-days maturity would be more accurate when: (1) using ARCH specifications in place of a moving average of squared returns; (2) using Hull and White's (1987) adjustment for stochastic variance in Black and Scholes's (1973) formula; (3) accounting explicitly for weekends and the slowdown of variance whenever the market is closed.
Keywords: variance forecasts; index options; stochastic volatility; GARCH
JEL Codes: G13; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| GARCH specifications (C58) | pricing accuracy (L11) |
| Hull and White's adjustment (C51) | pricing accuracy (L11) |
| weekend calendar variable (J29) | pricing outcomes (L11) |