Financial market crashes and spikes in implied volatility

Research output: Working paper

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DateIn preparation - 2012
Original languageEnglish

Abstract

This paper proposes a new model for option pricing that can hold even in the event of a major
financial market crisis. When stock return volatility is unobservable, a good indicator for its
behavior can be found in the volatility implied in the corresponding option market. S&P500
implied volatility during the year 1987 was characterized by very sharp movements in both
directions. Unlike existing models which only allow for dramatic increases in volatility, the
proposed model allows the stock return volatility to wander about its path without any
restrictions. This allows the volatility to either rise or fall violently while the entire process
remains positive. Option pricing errors are used to
estimate the risk premia embedded in the option prices. In the second stage, S&P500 option
prices are used to assess the empirical performance of the model via ex ante forecasts. The
estimates indicate that taking account of spikes in volatility significantly improves option
pricing.

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