Optimal Decisions in the Equity Index Derivatives Markets Using Option Implied Information

Abstract

This dissertation is centered around two comprehensive themes: the extraction of information embedded in equity index option prices, and how to use this information in order to be able to make optimal decisions in the equity index option markets. These problems are important for decision makers in the equity index options markets, since they are continuously faced with making decisions under uncertainty given observed market prices. The methods developed in this dissertation provide robust tools that can be used by practitioners in order to improve the quality of the decisions that they make.In order to be able to extract information embedded in option prices, the dissertation develops two different methods for estimation of stable option implied surfaces which are consistent with observed market prices. This is a difficult and ill-posed inverse problem which is complicated by the fact that observed option prices contain a large amount of noise stemming from market micro structure effects. Producing estimated surfaces that are stable over time is important since otherwise risk measurement of derivatives portfolios, pricing of exotic options and calculation of hedge parameters will be prone to include significant errors. The first method that we develop leads to an optimization problem which is formulated as a convex quadratic program with linear constraints which can be solved very efficiently. The second estimation method that we develop in the dissertation makes it possible to produce local volatility surfaces of high quality, which are consistent with market prices and stable over time. The high quality of the surfaces estimated with the second method is the crucial input to the research which has resulted in the last three papers of the dissertation.The stability of the estimated local volatility surfaces makes it possible to build a realistic dynamic model for the equity index derivatives market. This model forms the basis for the stochastic programming (SP) model for option hedging that we develop in the dissertation. We show that the SP model, which uses i Optimal Decisions in the Equity Index Derivatives Markets Using Option Implied Information generated scenarios for the squared local volatility surface as input, outperforms the traditional hedging methods that are described in the literature. Apart from having an accurate view of the variance of relevant risk factors, it is when building a dynamic model also important to have a good estimate of the expected values, and thereby risk premia, of those factors. We use a result from recently published research which lets us recover the real-world density from only a cross-section of observed option prices via a local volatility model. The recovered real-world densities are then used in order to identify and estimate liquidity premia that are embedded in option prices.We also use the recovered real-world densities in order to test how well the option market predicts the realized statistical characteristics of the underlying index. We compare the resu...

Decomposing the Option Pricing Problem : Estimating the Causal Factors: Interest Rates, Dividends, and Risk-Neutral Probabilities

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“…The non-Gaussian distribution and jumps in the empirical data are just two facts of several well-known and well-documented facts called stylized facts. For example, Cont (2001) and Barkhagen (2015) present overviews of such stylized facts.…”

“…The advantage of the local volatility is that it is very flexible in its possibility to reprice market prices and that it is (very) easy to exclude arbitrages, see e.g., Barkhagen (2015). However, this flexibility comes with two major drawbacks.…”

Optimization-Based Models for Measuring and Hedging Risk in Fixed Income Markets

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