Non-affine GARCH Option Pricing Models, Variance-Dependent Kernels, and Diffusion Limits

Alexandru Badescu, Zhenyu Cui and Juan-Pablo Ortega

Journal of Financial Econometrics, 2017, vol. 15, issue 4, 602-648

Abstract: This paper investigates the pricing and weak convergence of an asymmetric non-affine, non-Gaussian GARCH model when the risk neutralization is based on a variance-dependent exponential linear pricing kernel with stochastic risk aversion parameters. The risk-neutral dynamics are obtained for a general setting and its weak limit is derived. We show how several GARCH diffusions, martingalized via well-known pricing kernels, are obtained as special cases and we derive necessary and sufficient conditions for the presence of financial bubbles. An extensive empirical analysis using both historical returns and options data illustrates the advantage of coupling this pricing kernel with non-Gaussian innovations.

Keywords: bivariate diffusion limit; exponential linear variance-dependent pricing kernel; non-affine GARCH models; non-Gaussian innovations; option pricing (search for similar items in EconPapers)
JEL-codes: C58 G12 G13 (search for similar items in EconPapers)
Date: 2017
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Citations: View citations in EconPapers (9)

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