A semiparametric approach to option pricing and hedging

Ling Chen (Stanford)

After a brief review of Hutchinson, Lo and Poggio's (1994, J. Finance) nonparametric regression approach to pricing and hedging European options, we describe a semiparametric approach, which can be regarded as a hybrid of the traditional parametric method that involves the Black-Scholes formula and nonparametric regression applied to the residuals after fitting the parametric model. We use this semiparametric model to develop a new hedging strategy in the presence of transaction costs. An empirical study of the performance of the proposed approach and previous methods is conducted for S&P 500 futures options. This is joint work with Tze Leung Lai and Tiong-Wee Lim.