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Equity Correlations Implied By Index Options: Estimation And Model Uncertainty Analysis

Author

Listed:
  • Rama Cont

    (LPMA - Laboratoire de Probabilités et Modèles Aléatoires - UPMC - Université Pierre et Marie Curie - Paris 6 - UPD7 - Université Paris Diderot - Paris 7 - CNRS - Centre National de la Recherche Scientifique)

  • Romain Deguest

Abstract

We propose a method for constructing an arbitrage-free multiasset pricing model which is consistent with a set of observed single- and multiasset derivative prices. The pricing model is constructed as a random mixture of N reference models, where the distribution of mixture weights is obtained by solving a well-posed convex optimization problem. Application of this method to equity and index options shows that, whereas multivariate diffusion models with constant correlation fail to match the prices of index and component options simultaneously, a jump-diffusion model with a common jump component affecting all stocks enables to do so. Furthermore, we show that even within a parametric model class, there is a wide range of correlation patterns compatible with observed prices of index options. Our method allows, as a by product, to quantify this model uncertainty with no further computational effort and propose static hedging strategies for reducing the exposure of multiasset derivatives to model uncertainty.

Suggested Citation

  • Rama Cont & Romain Deguest, 2013. "Equity Correlations Implied By Index Options: Estimation And Model Uncertainty Analysis," Post-Print hal-00835272, HAL.
  • Handle: RePEc:hal:journl:hal-00835272
    DOI: 10.1111/j.1467-9965.2011.00503.x
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    Cited by:

    1. Carole Bernard & Oleg Bondarenko & Steven Vanduffel, 2021. "A model-free approach to multivariate option pricing," Review of Derivatives Research, Springer, vol. 24(2), pages 135-155, July.
    2. Coqueret, Guillaume & Tavin, Bertrand, 2016. "An investigation of model risk in a market with jumps and stochastic volatility," European Journal of Operational Research, Elsevier, vol. 253(3), pages 648-658.
    3. Tavin, Bertrand, 2015. "Detection of arbitrage in a market with multi-asset derivatives and known risk-neutral marginals," Journal of Banking & Finance, Elsevier, vol. 53(C), pages 158-178.
    4. Ban, Mingyuan & Chen, Chang-Chih, 2019. "Ambiguity and capital structure adjustments," International Review of Economics & Finance, Elsevier, vol. 64(C), pages 242-270.

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