Capturing Option Anomalies with a Variance-Dependent Pricing Kernel

Peter Christoffersen, Steven Heston, Kris Jacobs

Research output: Contribution to journalJournal articleResearchpeer-review

Abstract

We develop a GARCH option model with a new pricing kernel allowing for a variance premium. While the pricing kernel is monotonic in the stock return and in variance, its projection onto the stock return is nonmonotonic. A negative variance premium makes it U shaped. We present new semiparametric evidence to confirm this U-shaped relationship between the risk-neutral and physical probability densities. The new pricing kernel substantially improves our ability to reconcile the time-series properties of stock returns with the cross-section of option prices. It provides a unified explanation for the implied volatility puzzle, the overreaction of long-term options to changes in short-term variance, and the fat tails of the risk-neutral return distribution relative to the physical distribution.
Original languageEnglish
JournalReview of Financial Studies
Volume26
Issue number8
Pages (from-to)1963-2006
ISSN0893-9454
DOIs
Publication statusPublished - 2013

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