A Practical Guide to GMM (with Applications to Option Pricing)

Generalized Method of Moments (GMM) is underutilized in financial economics because it is not adequately explained in the literature. We use a simple example to explain how and why GMM works. We then illustrate practical GMM implementation by estimating and testing the Black-Scholes option pricing model using Samp;P 500 index options data. We identify problem areas in implementation and we give practical GMM estimation advice, troubleshooting tips, and pseudo code. We pay particular attention to proper choice of moment conditions, exactly-identified versus over-identified estimation, estimation of Newey-West standard errors, and numerical optimization in the presence of multiple extrema