Risk Premia and Lévy Jumps: Theory and Evidence
45 Pages Posted: 12 Feb 2019 Last revised: 5 Dec 2019
Date Written: January 25, 2019
To study jump and volatility risk premia in asset returns, we develop a novel class of time- changed Lévy models. Our models are characterized by flexible Lévy measures, and allow consistent estimation under physical and risk neutral measures. We derive the no-arbitrage conditions under which the risk premia can take general forms. To operationalize the models, we use volume based proxies for the unobservable time changes. An extensive time series and option pricing analysis of 16 time-changed Lévy models shows that infinite activity processes carry significant jump risk premia, and largely outperform many finite activity processes.
Keywords: Lévy jumps, time changes, tempered stable law, time series, option pricing
JEL Classification: C5, G12
Suggested Citation: Suggested Citation