Canonical valuation and hedging of index options

Philip Gray*, Shane Edwards, Egon Kalotay

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

10 Citations (Scopus)

Abstract

Canonical valuation is a nonparametric method for valuing derivatives proposed by M. Stutzer (1996). Although the properties of canonical estimates of option price and hedge ratio have been studied in simulation settings, applications of the methodology to traded derivative data are rare. This study explores the practical usefulness of canonical valuation using a large sample of index options. The basic unconstrained canonical estimator fails to outperform the traditional Black-Scholes model; however, a constrained canonical estimator that incorporates a small amount of conditioning information produces dramatic reductions in mean pricing errors. Similarly, the canonical approach generates hedge ratios that result in superior hedging effectiveness compared to Black- Scholes-based deltas. The results encourage further exploration and application of the canonical approach to pricing and hedging derivatives.

Original languageEnglish
Pages (from-to)771-790
Number of pages20
JournalThe Journal of Futures Markets
Volume27
Issue number8
DOIs
Publication statusPublished - Aug 2007

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