Pricing options using implied trees: Evidence from FTSE-100 options

✍ Scribed by Kian Guan Lim; Da Zhi

• Publisher: John Wiley and Sons
• Year: 2002
• Tongue: English
• Weight: 191 KB
• Volume: 22
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/fut.10019

✦ Synopsis

Abstract

Previously, few, if any, comparative tests of performance of Jackwerth's (1997) generalized binomial tree (GBT) and Derman and Kani (1994) implied volatility tree (IVT) models were done. In this paper, we
propose five different weight functions in GBT and test them empirically compared to both the
Black‐Scholes model and IVT.

We use the daily settlement prices of FTSE‐100 index options from January to November 1999. With both
American and European options traded on the FTSE‐100 index, we construct both GBT and IVT from European
options and examine their performance in both the hedging of European option and the pricing of its American
counterpart. IVT is found to produce least hedging errors and best results for American call options with earlier
maturity than the maturity span of the implied trees. GBT appears to produce better results for American ATM put
pricing for any maturity, and better in‐sample fit for options with maturity equal to the maturity span of
the implied trees. Deltas calculated from IVT are consistently lower (higher) than Black‐Scholes
deltas for both European and American calls (puts) in absolute term. The reverse holds true for GBT
deltas. These empirical findings about the relative performance of GBT, IVT, and Standard Black‐Scholes
models are important to practitioners as they indicate that different methods should be used for different
applications, and some cautions should be exercised. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark
22:601–626, 2002