Option Valuation with Volatility Components, Fat Tails, and Nonlinear Pricing Kernels

Kadir G. Babaoglou, Peter Christoffersen, Steven L. Heston () and Kris Jacobs ()
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Kadir G. Babaoglou: University of Toronto - Rotman School of Management, Postal: University of Toronto - Rotman School og Management, 105 St. George Street Toronto, Ontario M5S 3E6, Canada
Steven L. Heston: University of Maryland - Department of Finance, Postal: University of Maryland - Department of Finance, Robert H. Smith School of Business Van Munching Hall College Park, MD 20742, United States
Kris Jacobs: University of Houston - C.T. Bauer College of Business, Postal: University of Houston - C.T. Bauer College of Business, Houston, TX 77204-6021, United States
Authors registered in the RePEc Author Service: Kadir G. Babaoglu

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

Abstract: We nest multiple volatility components, fat tails and a U-shaped pricing kernel in a single option model and compare their contribution to describing returns and option data. All three features lead to statistically significant model improvements. A second volatility factor is economically most important and improves option fit by 18% on average. A U-shaped pricing kernel improves the option fit by 17% on average, and more so for two-factor models. Fat tails improve option fit by just over 3% on average, and more so when a U-shaped pricing kernel is applied. Our results suggest that the three features we investigate are complements rather than substitutes.

Keywords: volatility components; fat tails; jumps; pricing kernel (search for similar items in EconPapers)
JEL-codes: G12 (search for similar items in EconPapers)
Pages: 50
Date: 2014-11-18
New Economics Papers: this item is included in nep-cfn and nep-mkt
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Citations: View citations in EconPapers (5)

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