Estimation of parameters in the Information Based Asset Pricing Framework

Abstract

Stochastic volatility models have become common in pricing options due to their ability to capture the changes in the asset's volatility with time. The information based asset pricing framework proposed by Brody, Hughson and Macrina referred to the BHM model or BHM approach is an improvement to the existing stochastic volatility models as it incorporates information in determining the option price dynamics. The objective of this study is to extend the application of a non-linear ltering approach used in volatility extraction in the Heston model to the BHM model. The measurement and transition equations obtained in the state space model are used in the extended kalman lter to extract volatility. The BHM model from a Black-Scholes perspective updated in the results of the Gaussian Integrals is referred to the BS-BHM Updated model. The option price is obtained using this model and the parameters which cannot be observed directly in the model are estimated using the method of moments.

Keywords: BHM model, BS-BHM Updated model, method of moments, stochastic volatility.

DOI: 10.7176/MTM/9-5-08

Publication date: May 31st 2019