Stochastic Volatility and Asset Pricing Puzzles

Abstract

This paper builds a real-options model of the firm with stochastic volatility to shed new light on the value premium, financial distress, and credit spread puzzles. Since the equity of growth firms and financially distressed firms have embedded options, such securities hedge against volatility risk and command lower volatility risk premia than the equities of value or financially healthy firms. Conversely, corporate debt will tend to command large volatility risk premia, allowing the model to generate higher credit spreads than existing structural models. The paper develops a novel methodology based on asymptotic expansions to solve the model.

Keywords: Asset Pricing, Real Options, Stochastic Volatility

JEL Classification: G12, G13