Asset Variance Risk and Compound Option Prices
54 Pages Posted: 14 Jul 2021
Date Written: July 13, 2021
We evaluate the empirical validity of the compound option framework. In a model where corporate securities are options on a firm's assets, option contracts on these can be viewed as options on options, or compound options. We estimate a model with priced asset variance risk and find that it jointly explains the level and time variation of both equity index (SPX) and credit index (CDX) option prices well out-of-sample. This suggests that the two options markets are priced consistently, contrary to recent findings. We show that variance risk is important for establishing pricing consistency between equity, credit, and related derivatives.
JEL Classification: G12, G13
Suggested Citation: Suggested Citation