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Implied Pricing Kernels: An Alternative Approach for Option Valuation

Authors

  • Doojin Ryu,

    Corresponding author
    1. Doojin Ryu is at the College of Economics, Sungkyunkwan University, Jongno-gu, Seoul, Republic of Korea [Correction added on 19 December 2014, after first online publication: the affiliation “Financial Economics at the School of Economics, Chung-Ang University, Seoul, Republic of Korea” was changed to “College of Economics, Sungkyunkwan University, Jongno-gu, Seoul, Republic of Korea”]
    • Correspondence author, College of Economics, Sungkyunkwan University, 25-2, Sungkyunkwan-ro, Jongno-gu, Seoul 110-745, Republic of Korea. Tel: +82-2-760-0429, Fax: +82-2-760-0950, e-mail: doojin.ryu@gmail.com [Correction added on 19 December 2014, after first online publication: the affiliation “School of Economics, College of Business and Economics, Chung-Ang University, Heukseok-ro 84, Dongjak-gu, Seoul 156-756, Republic of Korea. Tel: +82-2-820-5495, Fax: +82-2-813-5487” was changed to “College of Economics, Sungkyunkwan University, Jongno-gu, Seoul, Republic of Korea. Tel: +82-2-760-0429, Fax: +82-2-760-0950”].

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  • Jangkoo Kang,

    1. Sangwon Suh is Professor of Financial Economics, School of Economics, Chung-Ang University, Seoul, Republic of Korea
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  • Sangwon Suh

    1. Jangkoo Kang is a Professor at the Graduate School of Finance and Accounting, Korea Advanced Institute of Science and Technology (KAIST), Seoul, Republic of Korea
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  • An earlier version of this study was presented at the 6th Conference of Asia-Pacific Association of Derivatives (APAD 2010) and at the 2011 KFA-TFA Joint Conference in Finance, which was held in the National Taiwan University. This paper is an extended version of the last chapter of Ryu's doctoral dissertation. The authors are grateful for the helpful comments and suggestions from an anonymous referee, Youngsoo Choi (the discussant), Biao Guo, Mehmet H. Bilgin, Qian Han, Jun Sik Kim, Sol Kim, Byungsun Min, Sun-Joong Yoon, Meng-Lan Yueh (the discussant), and Robert I. Webb (the editor).

Abstract

This study proposes a new estimation approach for option valuation (an implied pricing kernel-based approach), which estimates model parameters under the physical probability measure (P-measure) using a pricing kernel implied by the GARCH option pricing model. Analyzing the dataset on the KOSPI 200 options market, we examine the empirical performance of the implied pricing kernel-based approach and compare it with the performance of the classical GARCH option valuation approach (i.e., a pricing model-based approach) that estimates model parameters under the risk-neutral probability measure (Q-measure). As proposed in this study, the implied pricing kernel-based estimation approach requires approximation and discretization in order to derive the functional form of the pricing kernel. Regardless of this approximation, however, when it comes to pricing OTM calls, the implied pricing kernel-based approach performs slightly better than the pricing model-based approach that has been traditionally used for option valuation. Additional analysis based on the put option sample indicates that the implied pricing kernel-based approach clearly dominates the classical pricing model-based approach during the early stage of emergence of the KOSPI 200 options market (1999–2000) when the market was immature. During the recent global financial crisis (2007–2009), the pricing kernel-based approach also yields smaller pricing errors for OTM puts than the classical approach does. These empirical results imply that the new approach suggested in this study can be advantageous for option valuation, particularly when the information embedded in options prices is not sufficient for estimation and/or the market is speculative and volatile. © 2013 Wiley Periodicals, Inc. Jrl Fut Mark 35:127–147, 2015

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