Option Valuation with Macro-Finance Variables

We propose a new model in which option values are determined by economic variables. Given the price of the underlying asset and its volatility, the price of an option in the model depends on macroeconomic conditions. Using an index of current business conditions as the driver, the new model outperforms existing benchmarks in fitting underlying asset returns and in the pricing of options. The model performs particularly well when business conditions are deteriorating. Using the recent financial crisis as an out-of-sample experiment, the new model has option-pricing errors that are 18% below those of a nested two-component volatility benchmark