Original scientific paper
https://doi.org/10.1080/1331677X.2019.1638285
Probability weighting functions obtained from Hong Kong index option market
Xinyu Wu
; School of Finance, Anhui University of Finance and Economics, Bengbu, China
Haibin Xie
; School of Banking and Finance, University of International Business and Economics, Beijing, China
Xindan Li
; School of Management and Engineering, Nanjing University, Nanjing, China
Abstract
In this paper we estimate the pricing kernel from the Hong Kong index option market and obtain the empirical probability weighting functions based on the rank-dependent expected utility. The empirical pricing kernel is estimated semi-parametrically as the ratio of the risk-neutral and objective densities. We employ a two-step estimation procedure to estimate the objective and risk-neutral densities under a consistent parametric framework of the non-affine generalised autoregressive conditional heteroskedasticity (G.A.R.C.H.) diffusion model. In the first step, we develop a continuous particle filters-based maximum likelihood estimation method to estimate the objective parameters of the G.A.R.C.H. diffusion model using the Hang Seng Index (H.S.I.) returns. In the second step of our estimation, we depart from the usual pure calibration approach and use the H.S.I. option prices to estimate the risk-neutral parameters of the G.A.R.C.H. diffusion model by constraining certain parameters to be consistent with the time-series behaviour of H.S.I. returns. Based on the estimated objective and risk-neutral parameters, the objective and risk-neutral densities are obtained by inverting the corresponding characteristic functions. Empirical results indicate that the empirical pricing kernel estimated from the Hong Kong index option market is non-monotonic and the estimated probability weighting functions are S-shaped, which implies that investors underweight small probability events and overweight large ones
Keywords
Pricing kernel; probability weighting; rank-dependent utility; option prices; G.A.R.C.H. diffusion mode
Hrčak ID:
228866
URI
Publication date:
22.1.2019.
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