GARCH Option Pricing Models and the Variance Risk Premium

Wenjun Zhang and Jin E. Zhang
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Wenjun Zhang: Department of Mathematical Sciences, School of Engineering, Computer and Mathematical Sciences, Auckland University of Technology, Auckland 1142, New Zealand
Jin E. Zhang: Department of Accountancy and Finance, Otago Business School, University of Otago, Dunedin 9054, New Zealand

JRFM, 2020, vol. 13, issue 3, 1-21

Abstract: In this paper, we modify Duan’s (1995) local risk-neutral valuation relationship (mLRNVR) for the GARCH option-pricing models. In our mLRNVR, the conditional variances under two measures are designed to be different and the variance process is more persistent in the risk-neutral measure than in the physical one, so that one is able to capture the variance risk premium. Empirical estimation exercises show that the GARCH option-pricing models under our mLRNVR are able to price the SPX one-month variance swap rate, i.e., the CBOE Volatility Index (VIX) accurately. Our research suggests that one should use our mLRNVR when pricing options with GARCH models.

Keywords: GARCH option-pricing models; stochastic volatility; the CBOE VIX; variance risk premium (search for similar items in EconPapers)
JEL-codes: C E F2 F3 G (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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