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A lattice model for option pricing under GARCH-jump processes

Author

Listed:
  • Bing-Huei Lin
  • Mao-Wei Hung
  • Jr-Yan Wang
  • Ping-Da Wu

Abstract

This study extends the GARCH pricing tree in Ritchken and Trevor (J Financ 54:366–402, 1999 ) by incorporating an additional jump process to develop a lattice model to value options. The GARCH-jump model can capture the behavior of asset prices more appropriately given its consistency with abundant empirical findings that discontinuities in the sample path of financial asset prices still being found even allowing for autoregressive conditional heteroskedasticity. With our lattice model, it shows that both the GARCH and jump effects in the GARCH-jump model are negative for near-the-money options, while positive for in-the-money and out-of-the-money options. In addition, even when the GARCH model is considered, the jump process impedes the early exercise and thus reduces the percentage of the early exercise premium of American options, particularly for shorter-term horizons. Moreover, the interaction between the GARCH and jump processes can raise the percentage proportions of the early exercise premiums for shorter-term horizons, whereas this effect weakens when the time to maturity increases. Copyright Springer Science+Business Media New York 2013

Suggested Citation

  • Bing-Huei Lin & Mao-Wei Hung & Jr-Yan Wang & Ping-Da Wu, 2013. "A lattice model for option pricing under GARCH-jump processes," Review of Derivatives Research, Springer, vol. 16(3), pages 295-329, October.
    • Handle: RePEc:kap:revdev:v:16:y:2013:i:3:p:295-329
    DOI: 10.1007/s11147-012-9087-8
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    References listed on IDEAS

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    2. Gatfaoui, Hayette, 2016. "Linking the gas and oil markets with the stock market: Investigating the U.S. relationship," Energy Economics, Elsevier, vol. 53(C), pages 5-16.

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    More about this item

    Keywords

    GARCH-jump process; Option pricing; Lattice model ; GARCH process; Jump-diffusion process; G13;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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