Beyond black-scholes pricing of financial derivatives.

• Main Author: Chen, Jiateng.
• Other Authors: Cheong Siew Ann
• Format: Final Year Project
• Language: English
• Published: 2012
• Subjects: DRNTU::Business::Finance::Derivatives
• Online Access: http://hdl.handle.net/10356/49066
• Institution: Nanyang Technological University

During the recent global financial crisis regulators recognized the need for financial institutions to include derivatives in their balance sheets, for a more accurate assessment of the risks such firms face. This shift in accounting practice requires such instruments to be accurately valued. Nearly all derivative pricing models assume positive correlation between the volatilities of the derivative and its underlying security. This assumption is difficult to test using traditional statistical methods. However, this assumption requires sudden volatility changes in the security to be accompanied by sudden volatility changes in the derivative. To check this, we perform recursive segmentation on the high-frequency time series of the Dow Jones Industrial Average index (whose movements are described by a Gaussian process) and its future (whose trading intervals are described by an exponential process). In growth and crisis markets after 2005, except for a few cases, derivative volatility jumps correlated positively with security volatility jumps. By analyzing the news around major volatility jumps, we find the derivative responding strongly to speculation.