Estimation of a Stochastic Volatility Model Using Pricing and Hedging Information
23 Pages Posted: 25 Jan 2005
Date Written: September 2002
Abstract
Estimation of option pricing models in which the underlying asset exhibits stochastic volatility presents complicated econometric questions. One such question, thus far unstudied, is whether the inclusion of information derived from hedging relationships implied by an option pricing model may be used in conjunction with pricing information to provide more reliable parameter estimates than the use of pricing information alone. This paper estimates, using a simple least-squares procedure, the stochastic volatility model of Heston (1993), and includes hedging information in the objective function. This hedging information enters the objective function through a weighting parameter that is chosen optimally within the model. With the weight appropriately chosen, we find that incorporating the hedging information reduces both the out-of-sample hedging and pricing errors associated with the Heston model.
Keywords: Stochastic Volatility, Options, Hedging
JEL Classification: C13, G13
Suggested Citation: Suggested Citation