A Test of the Use of the Implied Volatility Function Model to Price Exotic Options
May 2000
John Hull, and Wulin Suo
ABSTRACT
Researchers such as Derman and Kani (1994), Dupire (1994), and Rubinstein (1994) have proposed a one-factor model
for asset prices that is exactly consistent with all European option prices. In this model, which we refer to as
the implied volatility function (IVF) model, the asset price volatility is a function of both time and the asset
price. Practitioners often use the IVF model to price exotic options. This paper explores the validity of this.
It does so by assuming a two-factor stochastic volatility model for the asset price and examining the way the IVF
model prices compound options and barrier options. We find the model works well for compound options, but sometimes
gives rise to large pricing errors for barrier options.
Subject: Investment/Derivatives,Valuation
Classification: Theoretical, Empirical
John Hull
Institution: Stern School of Business, New York University
Email: jhull@stern.nyu.edu
Telephone: (212) 998-0758
Home Page: http://www.stern.nyu.edu/~hull
Wulin Suo
Institution: Queens University
Email: wsuo@business.queensu.ca
Telephone: (613) 533-2337
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