Bivariate option pricing using dynamic copula models

This paper examines the behavior of bivariate option prices in the presence of association between the underlying assets. Parametric families of copulas offering various alternatives to the Gaussian dependence structure are used to model this association, which is explicitly assumed to vary over tim...

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Bibliographic Details
Published in:Insurance, mathematics & economics mathematics & economics, 2005-08, Vol.37 (1), p.101-114
Main Authors: van den Goorbergh, Rob W.J., Genest, Christian, Werker, Bas J.M.
Format: Article
Language:English
Subjects:
Archimedean copula
ARMA model
Best-of-two-markets options
Economic dynamics
Financial economics
Insurance
Kendall’s tau
Mathematical economics
Mathematical models
Mathematics
Methodology
Non-normality
Normal distribution
Option pricing
Regression analysis
Securities prices
Studies
Time-varying dependence
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Summary:This paper examines the behavior of bivariate option prices in the presence of association between the underlying assets. Parametric families of copulas offering various alternatives to the Gaussian dependence structure are used to model this association, which is explicitly assumed to vary over time as a function of the volatilities of the assets. These dynamic copula models are applied to better-of-two-markets and worse-of-two-markets options on the Standard and Poor’s 500 and Nasdaq indexes. Results show that option prices implied by dynamic copula models can differ substantially from prices implied by models that fix the dependence between the underlyings, particularly in times of high volatilities. In the study, the Gaussian copula also produced option prices that differed significantly from those induced by non-Gaussian copulas, irrespective of initial volatility levels. Within the class of alternatives considered, option prices were robust with respect to the choice of copula.
ISSN:0167-6687
1873-5959
DOI:10.1016/j.insmatheco.2005.01.008