Good Volatility, Bad Volatility and Option Pricing

Abstract

Advances in variance analysis permit the splitting of the total quadratic variation of a jump-diffusion process into upside and downside components. Recent studies establish that this decomposition enhances volatility predictions, and highlight the upside/downside variance spread as a driver of the asymmetry in stock price distributions. To appraise the economic gain of this decomposition, we design a new and flexible option pricing model in which the underlying asset price exhibits distinct upside and downside semi-variance dynamics driven by their model-free proxies. The new model outperforms common benchmarks, especially the alternative that splits the quadratic variation into diffusive and jump components.

Keywords: Dynamic Upside Volatility, Dynamic Downside Volatility, Dynamic Skewness, Realized Downside Volatility, Realized Upside Volatility

JEL Classification: G12