Cross-sectional tests of deterministic volatility functions

We study the cross-sectional performance of option pricing models in which the volatility of the underlying stock is a deterministic function of the stock price and time. For each date in our sample of FTSE 100 index option prices, we fit an implied binomial tree to the panel of all European style options with different strike prices and maturities and then examine how well this model prices a corresponding panel of American style options. We find that the implied binomial tree model performs no better than an ad-hoc procedure of smoothing Black-Scholes implied volatilities across strike prices and maturities. Our cross-sectional results complement the time-series findings of Dumas et al. [J. Finance 53 (1998) 2059]. © 2002 Elsevier Science B.V. All rights reserved.

Duke Scholars

Author Michael W. Brandt Fuqua School of Business