Option Valuation with Volatility Components, Fat Tails, and Non-Monotonic Pricing Kernels

Kadir Babaoglu, Peter Christoffersen, Steven L. Heston, Kris Jacobs

Research output: Working paperResearch

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 U-shaped pricing kernel is economically most important and improves option fit by 17% on average and more so for two-factor models. A second volatility component improves the option fit by 9% on average. Fat tails improve option fit by just over 4% on average, but more so when a U-shaped pricing kernel is applied. Overall these three model features are complements rather than substitutes: the importance of one feature increases in conjunction with the others.
Original languageEnglish
Place of PublicationToronto
PublisherRotman School of Management, University of Toronto
Number of pages53
DOIs
Publication statusPublished - Nov 2016
SeriesRotman School of Management Working Paper
Number2690888

Keywords

  • Volatility components
  • Fat tails
  • Jumps
  • Pricing kernel

Cite this

Babaoglu, K., Christoffersen, P., Heston, S. L., & Jacobs, K. (2016). Option Valuation with Volatility Components, Fat Tails, and Non-Monotonic Pricing Kernels. Rotman School of Management, University of Toronto. Rotman School of Management Working Paper, No. 2690888 https://doi.org/10.2139/ssrn.2690888