Premium
Estimating Early Exercise Premiums on Gold and Copper Options Using a Multifactor Model and Density Matched Lattices
Author(s) -
Hilliard Jimmy E.,
Hilliard Jitka
Publication year - 2015
Publication title -
financial review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.621
H-Index - 47
eISSN - 1540-6288
pISSN - 0732-8516
DOI - 10.1111/fire.12059
Subject(s) - econometrics , economics , geometric brownian motion , risk premium , kalman filter , jump , jump diffusion , standard deviation , mathematics , statistics , quantum mechanics , service (business) , physics , economy , diffusion process
We use the standard geometric Brownian motion augmented by jumps to describe the spot underlying and mean regressive models of interest rates and convenience yields as state variables for gold and copper prices. Estimates of parameters of the diffusion processes are obtained by the Kalman filter. Using these estimates, jump parameters are estimated in the second stage by least squares. Early exercise premia on puts and calls are computed using a lattice with probabilities assigned by the density matching technique. We find that while deep in the money options have greater absolute early exercise premiums, the early exercise premium is roughly constant as a percent of option price. Our findings also confirm that gold behaves like an investment asset and copper behaves like a commodity.