SFB 303 Discussion Paper No. B - 443

Author: Laurent, Jean-Paul, and Dietmar P.J. Leisen
Title: Building a Consistent Pricing Model from Observed Option Prices
Abstract: This paper constructs a model for the evolution of a risky security that is consistent with a set of observed call option prices. It explicitly treats the fact that only a discrete data set can be observed in practice. The framework is general and allows for state dependent volatility and jumps. The theoretical properties are studied. An easy procedure to check for arbitrage opportunities in market data is proved and then used to ensure the feasibility of our approach. The implementation is discussed: testing on market data reveals a U-shaped form for the "local volatility" depending on the state and, surprisingly, a large probability for strong price movements.
Keywords: Markov Chain, no-arbitrage, cross-entropy, model risk
JEL-Classification-Number: C51 G12 G13
Creation-Date: Dezember 1998
URL: ../1998/b/bonnsfb443.pdf

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