Option Valuation with Volatility Components, Fat Tails, and Nonmonotonic Pricing Kernels

Kadir Babaoğlu, Peter Christoffersen, Steven Heston, Kris Jacobs

Research output: Contribution to journalJournal articlepeer-review

Abstract

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.
Original languageEnglish
JournalThe Review of Asset Pricing Studies
Volume8
Issue number2
Pages (from-to)183–231
Number of pages49
ISSN2045-9920
DOIs
Publication statusPublished - Dec 2018

Keywords

  • Asset pricing
  • Trading volume
  • Bond interest rates

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