EUROPEAN CALL OPTION PRICING WITH GARCH-M (1,1) UNDERLYING PROCESS

• Main Author: Santoso, Jodi
• Format: Final Project
• Language: Indonesia
• Online Access: https://digilib.itb.ac.id/gdl/view/44305
• Institution: Institut Teknologi Bandung

Financial institutions, such as banks, investment companies and insurance companies, often include options of stocks in their investment portfolio. They are required to valuate correctly the prices of the options so that the options are not undervalued nor overvalued. Some option pricing models, including the Black-Scholes, assume that the volatility of stocks is constant. This assumption is too strict for risky underlying assets including stocks which have time-varying volatility of asset returns. Generalized Autoregressive Conditional Heteroskedastic (GARCH) (1,1) is one financial time series model often used to model the stochastic volatility. In GARCH (1,1) model, the volatility is dependent on the square of the return. The log-return of the stocks’ prices may be modelled by the GARCH-in-mean (1,1) or GARCH-M (1,1) model. Option pricing using GARCH-M (1,1) model is better than that using the classical Black-Scholes model since GARCH-M (1,1) model is better in describing the stocks’ returns dynamics; especially in the determination of the initial value of the conditional volatility according to the current trend of the stocks market.