NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Option Hedging Using Empirical Pricing Kernels

Joshua V. Rosenberg, Robert F. Engle

NBER Working Paper No. 6222
Issued in October 1997
NBER Program(s):   AP

This paper develops a method for option hedging which is consistent with time-varying preferences and probabilities. The preferences are expressed in the form of an empirical pricing kernel (EPK), which measures the state price per unit probability, while probabilities are derived from an estimated stochastic volatility model of the form GARCH components with leverage. State prices are estimated using the flexible risk-neutral density method of Rosenberg (1995) and a daily cross-section of option premia. Time-varying preferences over states are linked to a dynamic model of the underlying price to obtain a one-day ahead forecast of derivative price distributions and minimum variance hedge ratios. Empirical results suggest that risk aversion over S&P500 return states is substantially higher than risk aversion implied by Black-Scholes state prices and probabilities using long run estimates of S&P500 return moments. It is also found that the daily level of risk aversion is strongly positively autocorrelated, negatively correlated with S&P500 price changes,and positively correlated with the spread between implied and objective volatilities. Hedging results reveal that typical hedging techniques for out-of-the-money S&P500 index options, such as Black-Scholes or historical minimum variance hedging, are inferior to the EPK hedging method. Thus, time-varying preferences and probabilities appear to be an important factor in the day-to-day pricing of S&P500 options.

download in pdf format
   (3562 K)

email paper

This paper is available as PDF (3562 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w6222

Published: Rosenberg, Joshua V. and Robert F. Engle. "Empirical Pricing Kernels," Journal of Financial Economics, 2002, v64(3,Jun), 341-372.

Users who downloaded this paper also downloaded these:
Engle and Rosenberg w4958 Hedging Options in a GARCH Environment: Testing the Term Structure of Stochastic Volatility Models
Cho and Engle w7331 Modeling the Impacts of Market Activity on Bid-Ask Spreads in the Option Market
Bates w5129 Testing Option Pricing Models
Wei w6742 Currency Hedging and Goods Trade
Ahn, Boudoukh, Richardson, and Whitelaw w6158 Optimal Risk Management Using Options
 
Publications
Activities
Meetings
NBER Videos
Data
People
About

Support
National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us