A lattice model for option pricing under GARCH-jump processes

This study extends the GARCH pricing tree in Ritchken and Trevor (J Financ 54:366–402, 1999 ) by incorporating an additional jump process to develop a lattice model to value options. The GARCH-jump model can capture the behavior of asset prices more appropriately given its consistency with abundant...

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Bibliographic Details
Published in:Review of derivatives research 2013-10, Vol.16 (3), p.295-329
Main Authors: Lin, Bing-Huei, Hung, Mao-Wei, Wang, Jr-Yan, Wu, Ping-Da
Format: Article
Language:English
Subjects:
Derivatives
Economic statistics
Economic theory
Economics and Finance
Finance
Investments and Securities
Options markets
Options trading
Securities prices
Skewness
Stochastic models
Stock exchanges
Studies
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Summary:This study extends the GARCH pricing tree in Ritchken and Trevor (J Financ 54:366–402, 1999 ) by incorporating an additional jump process to develop a lattice model to value options. The GARCH-jump model can capture the behavior of asset prices more appropriately given its consistency with abundant empirical findings that discontinuities in the sample path of financial asset prices still being found even allowing for autoregressive conditional heteroskedasticity. With our lattice model, it shows that both the GARCH and jump effects in the GARCH-jump model are negative for near-the-money options, while positive for in-the-money and out-of-the-money options. In addition, even when the GARCH model is considered, the jump process impedes the early exercise and thus reduces the percentage of the early exercise premium of American options, particularly for shorter-term horizons. Moreover, the interaction between the GARCH and jump processes can raise the percentage proportions of the early exercise premiums for shorter-term horizons, whereas this effect weakens when the time to maturity increases.
ISSN:1380-6645
1573-7144
DOI:10.1007/s11147-012-9087-8