Capturing Option Anomalies with a Variance-Dependent Pricing Kernel

55 Pages Posted: 22 Jan 2010 Last revised: 7 Jun 2012

Peter Christoffersen

University of Toronto - Rotman School of Management; Copenhagen Business School; University of Aarhus - CREATES

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Steven L. Heston

University of Maryland - Department of Finance

Date Written: March 10, 2011

Abstract

We develop a GARCH option model with a variance premium by combining the Heston-Nandi (2000) dynamic with a new pricing kernel that nests Rubinstein (1976) and Brennan (1979). 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 semi-parametric evidence to conÂ…firm 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.

Keywords: Pricing kernel, stochastic volatility, overreaction, variance risk

JEL Classification: G12

Suggested Citation

Christoffersen, Peter and Jacobs, Kris and Heston, Steven L., Capturing Option Anomalies with a Variance-Dependent Pricing Kernel (March 10, 2011). AFA 2011 Denver Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1538394 or http://dx.doi.org/10.2139/ssrn.1538394

Peter Christoffersen

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5P 3C4
Canada
416-946-5511 (Phone)

HOME PAGE: http://www.christoffersen.com

Copenhagen Business School

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

University of Aarhus - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Kris Jacobs

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Steven L. Heston (Contact Author)

University of Maryland - Department of Finance ( email )

Robert H. Smith School of Business
Van Munching Hall
College Park, MD 20742
United States

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