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Specification Analysis of Option Pricing Models Based on Time-Changed Levy Processes

Author

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  • Jing-zhi Huang
  • Liuren Wu
Abstract
This article analyzes the specifications of option pricing models based on time-changed Levy processes. We classify option pricing models based on (i) the structure of the jump component in the underlying return process, (ii) the source of stochastic volatility, and (iii) the specification of the volatility process itself. We then consider a variety of model specifications within this framework, and investigate empirically what type of jump structure best describe the underlying price movement and whether stochastic volatility comes from jump or diffusion. We find that, to capture the behavior of the S&P 500 index options, one needs to incorporate an infinite activity jump component in the underlying asset return process, and also to include stochastic volatilities from two separate sources: both the jump and the diffusion components

Suggested Citation

  • Jing-zhi Huang & Liuren Wu, 2004. "Specification Analysis of Option Pricing Models Based on Time-Changed Levy Processes," Econometric Society 2004 North American Winter Meetings 405, Econometric Society.
    • Handle: RePEc:ecm:nawm04:405
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    References listed on IDEAS

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    More about this item

    Keywords

    Option pricing; Levy processes; time change; jumps; diffusion; stochastic volatility;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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