Derivative Pricing and Risk Management for Developing emerging Stock Markets: Proposals from Hypothetical Hedging Performance. A dissertation submitted to University of

Abstract

Emerging markets are on the edge of introducing derivative products; however, they are unable to calibrate and select from the models that are available in the literature due to the absence of real market derivative prices. The Black and Scholes (BS) model is the sole pricing model that is sufficient for pricing options based on stock index volatility. This is due to the fact that the sophistication of other models necessitates the calibration of additional parameters, which can only converge to true values when calibrated with options data. Moreover, a good part of mispricing under BS model can be addressed when volatility updated with time series information under risk neutral dynamics is used as a proxy to BS’s constant volatility calibrated from cross section of stock market information. Delta-hedged profit-loss distribution of hypothetical European derivatives without requiring real market option data under Proxy-BS pricing with several proxies from recent GARCH option pricing literature such as GARCH, NGARCH, GARCH Jump, GARCH Jumps Constant can provide information to emerging markets regarding which Proxy-BS model to use for derivative pricing; at least until real market option data , on developing indices, become available to calibrate and use more sophisticated option pricing model. Such delta-hedged profit-loss distribution can help emerging markets infer the Value-at-Risk and Expected Shortfall for any proxy choice. Then, for the sake of studying the relative riskiness of their chosen proxy-BS model, it can be replicated for number of developed country's indices such as S&P500 markets for which real option data are available. Ultimate goal of this research is to make proposals, with empirical evidence from developed countries derivative markets, regarding which developing country should follow what dynamic proxy for initial pricing of their derivative contracts in the absence of real market derivative contract data on their own indices.