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Pricing options using implied trees: Evidence from FTSE‐100 options
Author(s) -
Lim Kian Guan,
Zhi Da
Publication year - 2002
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/fut.10019
Subject(s) - valuation of options , black–scholes model , binomial options pricing model , econometrics , implied volatility , exotic option , maturity (psychological) , trinomial tree , index (typography) , volatility (finance) , economics , actuarial science , strike price , financial economics , computer science , developmental psychology , psychology , world wide web
Previously, few, if any, comparative tests of performance of Jackwerth's (1997) generalized binomial tree (GBT) and Derman and Kani (1994) implied volatility tree (IVT) models were done. In this paper, wepropose five different weight functions in GBT and test them empirically compared to both theBlack‐Scholes model and IVT. We use the daily settlement prices of FTSE‐100 index options from January to November 1999. With bothAmerican and European options traded on the FTSE‐100 index, we construct both GBT and IVT from Europeanoptions and examine their performance in both the hedging of European option and the pricing of its Americancounterpart. IVT is found to produce least hedging errors and best results for American call options with earliermaturity than the maturity span of the implied trees. GBT appears to produce better results for American ATM putpricing for any maturity, and better in‐sample fit for options with maturity equal to the maturity span ofthe implied trees. Deltas calculated from IVT are consistently lower (higher) than Black‐Scholesdeltas for both European and American calls (puts) in absolute term. The reverse holds true for GBTdeltas. These empirical findings about the relative performance of GBT, IVT, and Standard Black‐Scholesmodels are important to practitioners as they indicate that different methods should be used for differentapplications, and some cautions should be exercised. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark22:601–626, 2002