Capturing Option Anomalies with a Variance-Dependent Pricing Kernel
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. The Author 2013. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.
Year of publication: |
2013
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Authors: | Christoffersen, Peter ; Heston, Steven ; Jacobs, Kris |
Published in: |
Review of Financial Studies. - Society for Financial Studies - SFS. - Vol. 26.2013, 8, p. 1963-2006
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Publisher: |
Society for Financial Studies - SFS |
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