Recovering the real-world density and liquidity premia from option data

Barkhagen, Mathias; Blomvall, Jörgen; Platen, Eckhard

doi:10.1080/14697688.2015.1128117

Cited by 3 publications

(1 citation statement)

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“…Paper D (Barkhagen et al, 2015) In paper D we recover the real-world density for the underlying index from S&P500 Index options. The recovery of the real-world density relies in a first step on extracting high-quality estimates of the risk-neutral density surface from liquid options using the method developed in Barkhagen and Blomvall (2015b).…”

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confidence: 99%

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

Barkhagen¹

2015

Linköping Studies in Science and Technology. Dissertations

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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...

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Section: Summary Of Included Papersmentioning

confidence: 99%

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

Barkhagen¹

2015

Linköping Studies in Science and Technology. Dissertations

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Bilateral multiple gamma returns: Their risks and rewards

2020

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The bilateral gamma model for returns is naturally derived from the lognormal model. Maximizing entropy in a random time change delivers the symmetric variance gamma model. The asymmetric variance gamma follows on incorporating skewness. Differential speeds for the upward and downward motions lead to the bilateral gamma. A further generalizations results in the bilateral double gamma model when the speed parameter of the bilateral gamma model is itself taken to be gamma distributed on entropy maximization. A rich five to seven parameter specification of preferences renders possible the extraction of physical densities from option prices. The quality of such extraction is measured by examining the uniformity of the estimated distribution functions evaluated at realized forward returns. The economic value of risky returns is seen to embed three/five risk premia for the bilateral gamma/bilateral double gamma. For the bilateral gamma they are up and down side volatilities compensated in up and down side drifts, and the down side drift compensated in the up side drift. For the bilateral double gamma one adds in addition compensations for skewness. Results reveal a drop in the down side risk premium since the crisis with an increase in the recent period.

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