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The price of a smile: hedging and spanning in option markets

Subject

Finance

Publishing details

Authors / Editors

Buraschi A;Jackwerth J C

Publication Year

2000

Abstract

The volatility smile changed drastically around the crash of 1987 and new option pricing models have been proposed in order to accommodate that change. Deterministic volatility models allow for more °exible volatility surfaces but refrain from introducing additional risk-factors. Thus, options are still redundant securities. Alternatively, stochastic models introduce additional risk-factors and options are then needed for spanning of the pricing kernel. We develop a statistical test based on this di®erence in spanning. Using daily S&P500 index options data from 1986-1995, our tests suggest that both in- and out-of-the-money options are needed for spanning. The findings are inconsistent with deterministic volatility models but are consistent with stochastic models which incorporate additional priced risk-factors such as stochastic volatility, interest rates, or jumps.

Publication Research Centre

Institute of Finance and Accounting

Series Number

FIN 308

Series

IFA Working Paper

Available on ECCH

No


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