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The Journal of Derivatives

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The Impact of Jump Dynamics on the Predictive Power of Option-Implied Densities

Yaw-Huei Wang
The Journal of Derivatives Spring 2009, 16 (3) 9-22; DOI: https://doi.org/10.3905/JOD.2009.16.3.009
Yaw-Huei Wang
is an associate professor in the Department of Finance at National Taiwan University in Taipei, Taiwan.
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  • For correspondence: yhwang@management.ntu.edu.tw
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Abstract

This article examines whether incorporating jumps with stochastic volatility can improve the predictive power of option-implied densities of the FTSE 100 index. A general double-jump model is used to fit the market prices of options and to estimate “risk-neutral” densities. “Real-world” densities are then converted from their risk-neutral form by means of alternative statistical calibrations. Both the risk-neutral and real-world densities are evaluated over five forecast horizons using two different tests. The empirical results indicate that adding jumps into the price and/or volatility processes not only substantially lowers the fitting errors of option prices, but also improves the predictive power of risk-neutral densities. Furthermore, satisfactory density prediction was consistently provided by the real-world densities, which were not dependent on the addition of jumps, the approach used to construct the densities, or the prediction horizon.

TOPICS: Options, volatility measures, VAR and use of alternative risk measures of trading risk

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Vol. 16, Issue 3
Spring 2009
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The Impact of Jump Dynamics on the Predictive Power of Option-Implied Densities
Yaw-Huei Wang
The Journal of Derivatives Feb 2009, 16 (3) 9-22; DOI: 10.3905/JOD.2009.16.3.009

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The Impact of Jump Dynamics on the Predictive Power of Option-Implied Densities
Yaw-Huei Wang
The Journal of Derivatives Feb 2009, 16 (3) 9-22; DOI: 10.3905/JOD.2009.16.3.009
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    • Abstract
    • THE OPTION-PRICING MODEL
    • RISK-NEUTRAL AND REAL-WORLD DENSITIES
    • DENSITY PREDICTION EVALUATION
    • DATA
    • EMPIRICAL RESULTS
    • CONCLUSIONS
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