Pricing and hedging long-term options (Q1969824)

The authors study the difference between the short-term and long-term options. The following model that incorporates stochastic volatility, stochastic interest rates \(R(t)\) and random jumps is considered. Let the spot interest rate follow a square-root diffusion \[ dR(t)=[\theta_{R}-k_{R}R(t)] dt+\sigma_{R}\sqrt{R(t)} dw_{R}(t) \] where \(k_{R}, \theta_{R}/k_{R}\) and \(\sigma_{R}\) are respectively the speed of adjustment, the long-run mean, the volatility coefficient of process \(R(t)\); \(w_{R}(t)\) is a standard Brownian motion. The underlying stock is assumed to pay a constant dividend yield, denoted by \(\delta\), and its price \(S(t)\) changes, under risk-neutral measure, according to the jump-diffusion stochastic differential equation \[ dS(t)/S(t)=[R(t)-\delta-\lambda \mu_{J}]dt+ \sqrt{V(t)} dw_{S}(t)+J(t) dq(t), \] where \(V(t)\) also follow a square-root equation \[ dV(t)=[\theta_{V}-k_{V}V(t)] dt+ \sigma_{V}\sqrt{V(t)} dw_{V}(t). \] The intensity of the jump component is measured by \(\lambda\), the size of percentage price jumps at time \(t\) is represented by \(J(t)\), which is lognormal, identically and independently distributed over time with unconditional mean \(\mu_{J}\); \(q(t)\) is a Poisson counter with \[ P\{dq(t)=1\}=\lambda dt, \quad P\{dq(t)=0\}=1-\lambda dt. \] Finally, let \(\text{Cov}_{t}[dw_{S}(t),dw_{V}(t)]\equiv \rho dt\), \(q(t)\) and \(J(t)\) be uncorrelated with each other or with \(w_{S}(t)\) and \(w_{V}(t)\). The option pricing formula for a European put option is derived for the considered model. The authors study the option deltas and state-price densities under alternative models for short-term and long-term options. A description of the regular and LEAPS S\&P 500 option data is provided and the estimation of structural parameters by using the method of simulated moments is presented. The difference between information in short-term and long-term options is studied. The hedging of the underlying stock portfolio and evaluation of the relative effectiveness of the underlying asset, short-term and medium-term options in hedging LEAPS are presented.