Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in thePHLX Deutschemark Options

David S. Bates

NBER Working Paper No. 4596
Issued in December 1993
NBER Program(s):   AP

An efficient method is developed for pricing American options on combination stochastic volatility/jump-diffusion processes when jump risk and volatility risk are systematic and nondiversifiable, thereby nesting two major option pricing models. The parameters implicit in PHLX-traded Deutschemark options of the stochastic volatility/jump- diffusion model and various submodels are estimated over 1984-91, and are tested for consistency with the $/DM futures process and the implicit volatility sample path. The parameters implicit in options are found to be inconsistent with the time series properties of implicit volatilities, but qualitatively consistent with log- differenced futures prices. No economically significant implicit expectations of exchange rate jumps were found in full-sample estimation, which is consistent with the reduced leptokurtosis of $/DM weekly exchange rate changes over 1984-91 relative to earlier periods.

(486 K)

Published: Review of Financial Studies, Vol. 9, no. 1 (1996): 69-107.

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