Liquidity on GARCH Option Pricing
Date Issued
2008
Date
2008
Author(s)
Cheng, Kai-Ming
Abstract
Many empirical researches have indicated that the Black-Scholes option pricing model demonstrate systematic biases due to some unreasonable assumptions. In practice, Black-Scholes implied volatilities tend to vary depending on moneyness and time to maturities. In response to this problem, many researchers have devoted themselves to creating new option pricing models. In this paper, the pricing efficiency of Heston and Nandi GARCH (HN GARCH) model is examined on the AMEX option market. A total of twelve companies are sampled and classified by liquidity (trade volume), market capitalization, and P/E ratio. Analyses are then carried out using the MLE method on different categories of companies. It is found that, while HN GARCH model has smaller valuation errors overall, they appear to be ill-suited for valuation of small market capitalization companies and display notable underpricing for options of low P/E ratio companies. They do, however, do a good job modeling the option prices of lower liquidity companies, whose options are much more European in practice.
Subjects
Black-Scholes option pricing model
HN GARCH model
AMEX option market
MLE method
Liquidity
Type
thesis
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