Option Valuation with Long-run and Short-run Volatility Components

Peter Christoffersen, Kris Jacobs, Hayawat Ornthanalai and Yintian Wang (pchristoffersen@creates.au.dk)
Additional contact information
Yintian Wang: School of Economics and Management, University of Aarhus, Denmark and CREATES, Postal: 8000 Aarhus C, Denmark

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: This paper presents a new model for the valuation of European options, in which the volatility of returns consists of two components. One of these components is a long-run component, and it can be modeled as fully persistent. The other component is short-run and has a zero mean. Our model can be viewed as an affine version of Engle and Lee (1999), allowing for easy valuation of European options. The model substantially outperforms a benchmark single-component volatility model that is well-established in the literature, and it fits options better than a model that combines conditional heteroskedasticity and Poissonnormal jumps. The component model’s superior performance is partly due to its improved ability to model the smirk and the path of spot volatility, but its most distinctive feature is its ability to model the volatility term structure. This feature enables the component model to jointly model long-maturity and short-maturity options.

Keywords: Volatility term structure; GARCH; out-of-sample (search for similar items in EconPapers)
JEL-codes: G12 (search for similar items in EconPapers)
Pages: 49
Date: 2008-02-18
New Economics Papers: this item is included in nep-fmk
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (124)

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https://repec.econ.au.dk/repec/creates/rp/08/rp08_11.pdf (application/pdf)

Related works:
Journal Article: Option valuation with long-run and short-run volatility components (2008)
Working Paper: Option Valuation with Long-run and Short-run Volatility Components (2004)
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Persistent link: https://EconPapers.repec.org/RePEc:aah:create:2008-11

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