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Quoting multiasset equity options in the presence of errors from estimating correlations

Matthias Fengler & Peter Schwendner

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abstract Anyone using an option valuation model needs estimates of returns volatility. But volatility has been found to be hard to forecast accurately, partly because it varies randomly over time. Fortunately, the market provides a directly observable volatility estimate in the form of the implied volatility that can be backed out from an option’s market price. But for several increasingly popular types of options, the payoff distribution depends both on stock volatilities and also on the correlations among them. For such options, including basket options and options on the max or on the min, there are no dependable sources of implied correlations to use in pricing them. Correlations must be estimated from historical data, which leads to substantial estimation risk. In this article, Fengler and Schwendner describe a block bootstrap procedure that allows an investor to evaluate a multiasset option’s exposure to parameter risk from imperfectly estimated correlations. The results are translated into minimum bid-ask spreads that are required to account for this additional source of risk. - See more at: http://www.iijournals.com/doi/abs/10.3905/jod.2004.412362#st hash.CWbh7ahl.XyeZeyTV.dpuf
   
type journal paper
   
keywords basket options, worst and best of options, correlation risk
   
language English
kind of paper journal article
date of appearance 1-7-2004
journal Journal of Derivatives
publisher Institutional Investor Journals
ISSN 1074-1240
DOI 10.3905/jod.2004.412362#sthash.CWbh7ahl.vvzZ92vw.dpuf
volume of journal 11
number of issue 4
page(s) 43-54
review double-blind review
   
citation Fengler, M., & Schwendner, P. (2004). Quoting multiasset equity options in the presence of errors from estimating correlations. Journal of Derivatives, 11(4), 43-54, DOI:10.3905/jod.2004.412362#sthash.CWbh7ahl.vvzZ92vw.dpuf.