PRICING AND HEDGING CURRENCY AND STOCK INDEX FUTURES OPTIONS IN INFORMATION-TIME

Abstract

The information-time model developed by Chang, Chang and Lim (1997) is an innovative option pricing model to incorporate stochastic volatility and jump process and at the same time retain simplicity. We conduct an empirical test on the model using transaction data for DM, JY and SF currency futures options and S&P 500 index futures options from the CME, dating from Jan. 1992 to Jun. 1995. Our study shows that the IT model generally outperforms the Black's model in all the tests. Lower mispricing errors and dampened systematic biases are produced with IT model in in-sample and out-of-sample pricing tests. In dynamic hedging tests, IT model reports higher hedging efficiency and more abnormal profit except for ATM options, though it exhibits slightly larger systematic risks. Moreover, the model's better performance relative to Black's model persists over the entire sample period. These evidence indicate that the IT model is a better alternative to the Black's formula as it has incorporated price dynamics with leptokurtosis and bore closer resemblance to reality.