We nest multiple volatility components, fat tails, and a U-shaped pricing kernel in a single option model and compare their contribution in 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.
- Asset pricing
- Trading volume
- Bond interest rates
Babaoğlu, K., Christoffersen, P., Heston, S., & Jacobs, K. (2018). Option Valuation with Volatility Components, Fat Tails, and Nonmonotonic Pricing Kernels. The Review of Asset Pricing Studies, 8(2), 183–231. https://doi.org/10.1093/rapstu/rax021