Overnight volatility, realized volatility, and option pricing

Tianyi Wang (), Sicong Cheng, Fangsheng Yin and Mei Yu

Journal of Futures Markets, 2022, vol. 42, issue 7, 1264-1283

Abstract: The equity market is not trading around the clock, and the overnight information has been proved be important for understanding pricing anomalies, improving volatility forecasting accuracy, and so forth. However, there is little research investigating its impact on option pricing. In this paper, we provide a framework that integrates intraday, overnight returns, and realized volatility simultaneously within an augmented Autoregressive Volatility model. The analytical option‐pricing formula for the new model is derived through the closed‐form moment generation function. The empirical results based on S&P 500 index options show that distinguishing the overnight component from daily returns has the potential capability to reduce the pricing errors, both in‐sample and out‐of‐sample.

Date: 2022
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