Business Conditions, Market Volatility and Option Prices
March 15, 2012
Options are bets on volatility. Volatility is highly counter-cyclical, but the volatility models used to value options typically disregard macroeconomic risk when predicting future volatility. The asset pricing properties of these models suffer from this omission; their option pricing errors tend to increase as business conditions deteriorate. We propose the use of a model in which the conditional expected level of volatility evolves with business conditions and, as a result, that accounts for macroeconomic risk. This risk is quantified using a mixed data sampling (MIDAS) structure to account for changes in the recently introduced Aruoba-Diebold-Scotti (ADS) Business Conditions Index. The new model outperforms existing ones in explaining asset returns and in the pricing of options, especially when business conditions are at their worst.
Number of Pages in PDF File: 41
Keywords: Business Conditions, Macroeconomic Risk, GARCH, Mixed Data Sampling, Option Valuation, Volatility
JEL Classification: C22, E32, G13working papers series
Date posted: May 17, 2010 ; Last revised: March 18, 2012
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