The price of a smile: hedging and spanning in option markets

Buraschi, A and Jackwerth, J C (2000) The price of a smile: hedging and spanning in option markets. Working Paper. London Business School IFA Working Paper.

Abstract

The volatility smile changed drastically around the crash of 1987 and new option pricing models have been proposed in order to accommodate that change. Deterministic volatility models allow for more °exible volatility surfaces but refrain from introducing additional riskfactors. Thus, options are still redundant securities. Alternatively, stochastic models introduce additional riskfactors and options are then needed for spanning of the pricing kernel. We develop a statistical test based on this di®erence in spanning. Using daily S&P500 index options data from 19861995, our tests suggest that both in and outofthemoney options are needed for spanning. The findings are inconsistent with deterministic volatility models but are consistent with stochastic models which incorporate additional priced riskfactors such as stochastic volatility, interest rates, or jumps.