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- Title
Capturing Option Anomalies with a Variance-Dependent Pricing Kernel.
- Authors
Christoffersen, Peter; Heston, Steven; Jacobs, Kris
- 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.
- Subjects
MATHEMATICAL models of option; MATHEMATICAL models of pricing; STOCK prices; PRICES of securities; FINANCIAL markets; MARKET volatility; KERNEL (Mathematics)
- Publication
Review of Financial Studies, 2013, Vol 26, Issue 8, p1963
- ISSN
0893-9454
- Publication type
Article
- DOI
10.1093/rfs/hht033