Option Valuation with Volatility Components, Fat Tails, and Non-Monotonic Pricing Kernels
53 Pages Posted: 14 Nov 2015 Last revised: 30 Apr 2017
Date Written: April 29, 2017
We nest multiple volatility components, fat tails and a U-shaped pricing kernel in a single option model and compare their contribution to describing returns and option data. All three features lead to statistically significant model improvements. A U-shaped pricing kernel is economically most important and improves option fit by 17% on average and more so for two-factor models. A second volatility component improves the option fit by 9% on average. Fat tails improve option fit by just over 4% on average, but more so when a U-shaped pricing kernel is applied. Overall these three model features are complements rather than substitutes: the importance of one feature increases in conjunction with the others.
Keywords: volatility components, fat tails, jumps, pricing kernel
JEL Classification: G12
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