The Roles of Short-Run and Long-Run Volatility Factors in Options Market: A Term Structure Perspective

54 Pages Posted: 14 Mar 2011

See all articles by Yang-Ho Park

Yang-Ho Park

Board of Governors of the Federal Reserve System

Date Written: March 11, 2011

Abstract

This paper examines the option pricing implications of short-run and long-run volatility factors, which are assumed to be driven by short-run and long-run news events, respectively. Using a comprehensive dataset of S&P 500 index options over 1993-2008, I find that the proposed two-factor volatility models have two desirable properties that help capture the term structures of option-implied volatility and skewness. First, the options data show evidence of time-variation in the long-run expectation of volatility, which may be caused by long-run news events. While this feature is inconsistent with a single-factor volatility assumption, the two-factor volatility models do a good job of matching the entire term structure of implied volatility. Second, the options data reveal that the term structure of implied skewness is nearly flat on average. This feature is hard to reconcile with single-factor volatility models and jumps in returns. In contrast, I find that the two-factor volatility models can generate flat term structures much like those seen in the data. In particular, the short-run volatility factor is dominant in generating short-term skewness, while the long-run volatility factor plays a pivotal role in generating long-term skewness.

Keywords: Option Pricing, Stochastic Volatility, Long-Run Volatility, Volatility Smirk, Skewness

JEL Classification: G12, G13

Suggested Citation

Park, Yang-Ho, The Roles of Short-Run and Long-Run Volatility Factors in Options Market: A Term Structure Perspective (March 11, 2011). Available at SSRN: https://ssrn.com/abstract=1783937 or http://dx.doi.org/10.2139/ssrn.1783937

Yang-Ho Park (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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