Working Paper Series: Finance & Accounting No. 140
When options are traded, one can use their prices and price changes to draw inference about the set of risk factors and their risk premia. We analyze tests for the existence and the sign of the market prices of jump risk that are based on option hedging errors. We derive a closed-form solution for the option hedging error and its expecta- tion in a stochastic jump model under continuous trading and correct model specification. Jump risk is structurally different from, e.g., stochastic volatility: there is one market price of risk for each jump size (and not just the market price of jump risk). Thus, the expected hedging error cannot identify the exact structure of the compensation for jump risk. Furthermore, we derive closed form solutions for the expected option hedging error under discrete trading and model mis-specification. Compared to the ideal case, the sign of the expected hedging error can change, so that empirical tests based on simplifying assumptions about trading frequency and the model may lead to incorrect conclusions.
Stochastic jumps market prices of risk discrete trading model mis-specification hedging error