Structural Stochastic Volatility

Abstract

A novel closed-form pricing formula for short-maturity options is employed to jointly identify
equity characteristics (spot volatility, spot leverage, and spot volatility of volatility) which have
been the focus of large, but separate, strands of the literature. Interpreting equity as a call option
on asset values, all equity characteristics should depend on structural sources of risk, such
as the variance of the firm’s assets and the extent of the firm’s financial leverage. We confirm
the implications of theory with data, thereby providing support for relations (like the link between
spot leverage and the firm’s financial leverage) broadly considered empirically ambiguous.

Keywords: short-maturity options, equity characteristics, Merton's model, nancial leverage, credit spreads.

JEL Classification: C51, C52, G12