Canonical valuation and hedging of index options

Canonical valuation is a nonparametric method for valuing derivatives proposed by M. Stutzer (1996). Although the properties of canonical estimates of option price and hedge ratio have been studied in simulation settings, applications of the methodology to traded derivative data are rare. This study explores the practical usefulness of canonical valuation using a large sample of index options. The basic unconstrained canonical estimator fails to outperform the traditional Black–Scholes model; however, a constrained canonical estimator that incorporates a small amount of conditioning information produces dramatic reductions in mean pricing errors. Similarly, the canonical approach generates hedge ratios that result in superior hedging effectiveness compared to Black–Scholes‐based deltas. The results encourage further exploration and application of the canonical approach to pricing and hedging derivatives. © 2007 Wiley Periodicals, Inc. Jnl Fut Mark 27: 771–790, 2007