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Option Pricing with State-dependent Pricing Kernel

Chen Tong, Peter Hansen and Zhuo Huang ()

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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
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