Option Valuation with Macro-Finance Variables
Journal of Financial and Quantitative Analysis, Vol. 51, No. 4, pp 1359-1389, August 2016
59 Pages Posted: 17 May 2010 Last revised: 16 Nov 2016
Date Written: December 20, 2013
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.
Keywords: Option valuation; Volatility; Macroeconomic risk; Business conditions; Mixed data sampling; GARCH
JEL Classification: C22, E32, G13
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