Title: Spatial dependence in option observation errors
Authors: Torben G Andersen - Kellogg School, Northwestern University (United States) [presenting]
Viktor Todorov - Northwestern University (United States)
Nicola Fusari - Kellogg School of Management (United States)
Rasmus Varneskov - Copenhagen Business School (Denmark)
Abstract: A nonparametric test is developed for deciding whether the observation error in option panels has spatial dependence. The option panel consists of options written on an underlying asset with different strikes and times to maturity. The asymptotic setup is of infill type: the mesh of the strike grids of the observed options shrinks asymptotically to zero while keeping the set of observation times and maturities fixed. We propose a Ljung-Box type test for testing the null hypothesis of no spatial dependence in the observation error. The test makes use of the smoothness of the true (unobserved) option price as a function of its strike and is robust to presence of heteroskedasticity of unknown form in the observation error. A Monte Carlo study shows good finite sample properties of the developed testing procedure and empirical application to S\&P 500 index option data reveals mild spatial dependence in the observation error which has declined over time.