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The price of a smile: hedging and spanning in option markets |
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| Authors: | Buraschi A; Jackwerth J |
| Institution: | 1 The University of Chicago, Chicago, IL, USA z London Business School, Sussex Place, Regent's Park, London NW1 4SA, UK 2 University of Wisconsin at Madison, Madison, WI, USA Corresponding author/address E-mail: aburaschi@london.edu |
| Abstract: | The volatility smile changed drastically around the crash of1987, and new option pricing models have been proposed to accommodatethat change. Deterministic volatility models allow for moreflexible volatility surfaces but refrain from introducing additionalrisk 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 difference in spanning.Using daily S&P 500 index options data from 1986-1995, ourtests suggest that both in- and out-of-the-money options areneeded for spanning. The findings are inconsistent with deterministicvolatility models but are consistent with stochastic modelsthat incorporate additional priced risk factors, such as stochasticvolatility, interest rates, or jumps. |
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