Option Pricing with State-dependent Pricing Kernel

Chen Tong, Peter Hansen and Zhuo Huang ()

Papers from arXiv.org

Abstract: We introduce a new volatility model for option pricing that combines Markov switching with the Realized GARCH framework. This leads to a novel pricing kernel with a state-dependent variance risk premium and a pricing formula for European options, which is derived with an analytical approximation method. We apply the Markov switching Realized GARCH model to S&P 500 index options from 1990 to 2019 and find that investors' aversion to volatility-specific risk is time-varying. The proposed framework outperforms competing models and reduces (in-sample and out-of-sample) option pricing errors by 15% or more.

Date: 2021-12, Revised 2022-04
New Economics Papers: this item is included in nep-cwa, nep-ets, nep-ore and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
http://arxiv.org/pdf/2112.05308 Latest version (application/pdf)

Related works:
Journal Article: Option pricing with state‐dependent pricing kernel (2022)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:2112.05308

Access Statistics for this paper

More papers in Papers from arXiv.org
Bibliographic data for series maintained by arXiv administrators ().