What's Beneath the Surface? Option Pricing with Multifrequency Latent States

• Activity Number: 347
• Type: Topic Contributed
• Date/Time: Tuesday, August 6, 2013 : 10:30 AM to 12:20 PM
• Sponsor: Business and Economic Statistics Section
• Author(s): Laurent Calvet*+ and Marcus Fearnley and Adlai Fisher and Markus Leippold
• Companies: HEC Paris and HEC Paris and University of British Columbia and University of Zurich
• Keywords: Markov-switching multifractal ; particle filter ; regime-switching ; stochastic volatility ; jump-risk premium ; option pricing

Abstract

We introduce a tractable class of non-affine price processes with multifrequency stochastic volatility and jumps. The specifications require few fixed parameters and deliver fast option pricing. One key ingredient is a tight link between jumps and volatility regimes, as asset pricing theory suggests. Empirically, the model matches implied volatility surfaces and their dynamics without requiring parameter recalibration. A variety of metrics show improvements over traditional benchmarks in- and out-of-sample.