Option Valuation with Volatility Components, Fat Tails, and Non-Monotonic Pricing Kernels

53 Pages Posted: 14 Nov 2015 Last revised: 30 Apr 2017

Kadir Babaoglu

Royal Bank of Canada, Capital Markets (Toronto)

Peter Christoffersen

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

Steven L. Heston

University of Maryland - Department of Finance

Kris Jacobs

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

Date Written: April 29, 2017

Abstract

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

Suggested Citation

Babaoglu, Kadir and Christoffersen, Peter and Heston, Steven L. and Jacobs, Kris, Option Valuation with Volatility Components, Fat Tails, and Non-Monotonic Pricing Kernels (April 29, 2017). Rotman School of Management Working Paper No. 2690888; Robert H. Smith School Research Paper No. RHS 2690888. Available at SSRN: https://ssrn.com/abstract=2690888 or http://dx.doi.org/10.2139/ssrn.2690888

Kadir Babaoglu

Royal Bank of Canada, Capital Markets (Toronto) ( email )

Canada

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

Peter Christoffersen (Contact Author)

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

Steven L. Heston

University of Maryland - Department of Finance ( email )

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

Kris Jacobs

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

Houston, TX 77204-6021
United States

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