New Economics Papers
on Financial Markets
Issue of 2009‒08‒16
two papers chosen by

  1. The Shape and Term Structure of the Index Option Smirk: Why Multifactor Stochastic Volatility Models Work so Well By Peter Christoffersen; Steven Heston; Kris Jacobs
  2. The Pricing of Bank Debt Guarantees By Stefan Arping

  1. By: Peter Christoffersen (McGill University and CREATES); Steven Heston (R.H. Smith School of Business, University of Maryland); Kris Jacobs (McGill University and Tilburg University)
    Abstract: State-of-the-art stochastic volatility models generate a "volatility smirk" that explains why out-of-the-money index puts have high prices relative to the Black-Scholes benchmark. These models also adequately explain how the volatility smirk moves up and down in response to changes in risk. However, the data indicate that the slope and the level of the smirk fluctuate largely independently. While single-factor stochastic volatility models can capture the slope of the smirk, they cannot explain such largely independent fluctuations in its level and slope over time. We propose to model these movements using a two-factor stochastic volatility model. Because the factors have distinct correlations with market returns, and because the weights of the factors vary over time, the model generates stochastic correlation between volatility and stock returns. Besides providing more flexible modeling of the time variation in the smirk, the model also provides more flexible modeling of the volatility term structure. Our empirical results indicate that the model improves on the benchmark Heston model by 24% in-sample and 23% out-of-sample. The better fit results from improvements in the modeling of the term structure dimension as well as the moneyness dimension.
    Keywords: Stochastic correlation, stochastic volatility, equity index options, multifactor model, persistence, affine, out-of-sample
    JEL: G12
    Date: 2009–06–17
  2. By: Stefan Arping (University of Amsterdam)
    Abstract: We analyze the optimal pricing of government-sponsored bank debt guarantees within the context of an asset substitution framework. We show that the desirability of fair pricing of guarantees depends on the degree of transparency of the banking sector: in relatively opaque banking systems, fair pricing exacerbates banks' incentive to take excessive risks, whereas the opposite is true in relatively transparent banking systems.
    Keywords: Debt Guarantees; Fair Pricing; Financial Stability
    JEL: G21 G38
    Date: 2009–06–30

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