Asset Pricing Results in Option Markets: True, Spurious, or Overlooked?
Comprehensive simulation analysis explores microstructure biases in delta-hedged option returns and proposes adjustments to improve asset pricing accuracy.
What it examines
This paper uses simulation methods to examine biases in delta-hedged option returns caused by microstructure noise and rebalancing frequency. It separates direct and indirect bias components, and proposes a simple delta-lagging adjustment to mitigate spurious results, aiming to improve the accuracy of asset pricing tests in option markets.
What it concludes
The study finds that high-frequency hedging amplifies bias, especially the indirect bias, but the delta-lagging adjustment effectively reduces errors. These results enhance asset pricing tests and can be applied in risk management, trading strategies, and market regulation. Future research may extend this approach to other derivatives.
Evidence objects
The study reveals that delta-hedging frequency significantly introduces measurement biases, as the indirect mean return ($IMR$) bias increases with higher rebalancing, potentially misleading analysis of risk premiums without proper adjustments.
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Surprisingly, high-frequency hedging data, despite offering precision, can generate significant spurious returns that falsely signal risk premiums, emphasizing the necessity of adjusting for these biases using innovative hedging techniques effectively.
key_findings bullet 2 · key_findings · validation V0
The authors propose a simple delta-lagging adjustment, decoupling hedge ratio errors from stock returns, while employing extensive simulations with Black--Scholes, Leland, and Heston models to realistically capture market trading complexities.
key_findings bullet 3 · key_findings · validation V0
This paper innovatively tackles critical option market pricing challenges by analyzing microstructure biases in $\Delta$-hedged returns, employing a simulation environment to explore hedge frequency impacts. Its refined methodology using lagged hedge ratios offers novel insights and enhances bias correction techniques. The papers originality makes it compelling for quantitative finance researchers.
key_findings bullet 4 · key_findings · validation V0
Raw abstract and provenance
- … Ct denotes the price of the option, St the price of the underlying security, and ∆t the delta of the option at time t. r is the constant annual risk-free rate. The starting point is a …
Source row: 253 · abstract type: snippet