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Pricing FTSE 100 index options under stochastic volatility
Author(s) -
Lin YuehNeng,
Strong Norman,
Xu Xinzhong
Publication year - 2001
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/1096-9934(200103)21:3<197::aid-fut1>3.0.co;2-3
Subject(s) - stochastic volatility , implied volatility , volatility smile , economics , forward volatility , econometrics , autoregressive conditional heteroskedasticity , heteroscedasticity , volatility swap , volatility (finance) , valuation of options , black–scholes model , sabr volatility model , autoregressive model , financial economics
The autoregressive conditional heteroscedasticity/generalized autoregressive conditional heteroscedasticity (ARCH/GARCH) literature and studies of implied volatility clearly show that volatility changes over time. This article investigates the improvement in the pricing of Financial Times‐Stock Exchange (FTSE) 100 index options when stochastic volatility is taken into account. The major tool for this analysis is Heston’s (1993) stochastic volatility option pricing formula, which allows for systematic volatility risk and arbitrary correlation between underlying returns and volatility. The results reveal significant evidence of stochastic volatility implicit in option prices, suggesting that this phenomenon is essential to improving the performance of the Black–Scholes model (Black & Scholes, 1973) for FTSE 100 index options. © 2001 John Wiley & Sons, Inc. Jrl Fut Mark 21:197–211, 2001