EVIDENCE ON DELTA HEDGING AND IMPLIED VOLATILITIES FOR
THE BLACK-SCHOLES, GAMMA, AND WEIBULL OPTION
PRICING MODELS

Modifying the distributional assumptions of the Black-Scholes model is one way to accommodate the skewness of underlying asset returns. Simple models based on the compensated gamma and Weibull distributions of asset prices are shown to produce some improvements in option pricing. To evaluate these assertions, I construct and compare delta hedges of all S&P 500 options traded on the Chicago Board Options Exchange between September 2001 and October 2003 for the Weibull, Black-Scholes, and gamma models. I also compare implied volatilities and their smiles (i.e., nonlinearities) among the three models. None of the three models improves over the others as far as delta hedging is concerned. Volatilities implied by all three models exhibit statistically significant smiles.

Unlike most option pricing models, the gamma and Weibull models in Heston (1993) and Savickas (2002) do not give up the estimation and implemen- tation simplicity to achieve improvements over the Black-Scholes (1973) model. The usefulness of these models for hedging and implied volatility estimation is of great practical interest, as both are designed to incorporate the skewness of under- lying returns. I use the two models, along with Black-Scholes, to delta hedge all S&P 500 options traded on the Chicago Board Options Exchange (CBOE) between September 2001 and October 2003.1The results indicate that there is no clear ad- vantage to incorporating the skewness of returns for delta hedging, as none of the three models provides consistently cheaper delta hedges. Also, all three models exhibit strong implied volatility smiles.

I am grateful to William T. Moore (the editor) and Charles Corrado of University of Technology\u2013 Sydney (the referee) for many helpful suggestions. All remaining errors are my own. Research support was received from the School of Business at the George Washington University.

where\u00b5 and\u03c3> 0 are the parameters of the distribution. The form of the three- parameter density function in the gamma model of Heston (1993) depends on the sign of the parameter\u03bb:

In equations (2) and (3),CLG andNCLG stand for compensated log gamma and negative compensated log gamma distributions, respectively. Finally, when prices are distributed Weibull with parametersa > 0 andb > 0, the density is:

An example of the four densities with the same means and variances is shown in the top panel of Figure I. Clearly, the applicability of the log normal assumption crucially depends on the underlying prices being positively skewed. The Weibull density, on the other hand, is more symmetric and is predominantly negatively skewed (see Savickas 2002), which makes it useful only for derivatives on negatively skewed assets. Furthermore, I show that the skewness coefficient of underlying returns is independent of Weibull parameters, which underlines the inflexibility of the Weibull model relative to Heston\u2019s (1993) gamma model. The latter is most versatile and, depending on the value of the parameter\u03bb, allows both positive and negative skewness in the underlying prices. This flexibility is a consequence of assuming a three-parameter distribution (as opposed to only two

Normal
Exp-Weibull
CG
NCG

LogNormal
Weibull
CLG
NCLG

Figure I. Log Normal, Compensated Log Gamma (CLG), Negative Compensated Log Gamma (NCLG), Weibull, Normal, Compensated Gamma (CG), Negative Compensated Gamma (NCG), and Exponent-Weibull Densities.The top panel shows the log normal, compensated

log gamma, negative-compensated log gamma, and Weibull densities with the same mean of 10.0 and same variance of 5.0. The bottom panel shows normal, compensated gamma, negative- compensated gamma, and exponent-Weibull densities with the same mean of 0.0 and same variance of 1.0. The parameter\u03b4 for CLG, NCLG, CG, and NCG distributions is chosen so that the skewness coefficient of the underlying returns under the negative-compensated gamma and Weibull models is the same and equal to\u22121.147838621.

parameters). Note, however, that the negative skewness in the gamma model can be achieved only by placing the upper limit of e\u00b5on asset prices. This constraint is not necessarily binding, as the value of\u00b5 could, in principle, be chosen sufficiently high.

Given the current priceS0, a price relativeSt/S 0is distributed according to one of the distributions in equations (1), (2) \u2013 (3), or (5). Therefore the log return ln(St/S0) is normal under log normal prices:

where the parameters\u00b5 and\u03c3 are the same as in equation (1). In the case of Heston\u2019s (1993) gamma model, the return is distributed either as compensated gamma (CG) or negative compensated gamma (NCG), depending on the value of the parameter