Option Valuation with Long-Run and Short-Run Volatility Components

51 Pages Posted: 11 Feb 2005 Last revised: 22 Jan 2012

Peter Christoffersen

University of Toronto - Rotman School of Management; Copenhagen Business School; University of Aarhus - CREATES

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Chayawat Ornthanalai

University of Toronto - Rotman School of Management

Yintian Wang

McGill University - Desautels Faculty of Management

Date Written: February 18, 2008

Abstract

This paper presents a new model for the valuation of European options, in which the volatility of returns consists of two components. One of these components is a long-run component, and it can be modeled as fully persistent. The other component is short-run and has a zero mean. Our model can be viewed as an affine version of Engle and Lee (1999), allowing for easy valuation of European options. The model substantially outperforms a benchmark single-component volatility model that is well-established in the literature, and it fits options better than a model that combines conditional heteroskedasticity and Poisson-normal jumps. The component model's superior performance is partly due to its improved ability to model the smirk and the path of spot volatility, but its most distinctive feature is its ability to model the volatility term structure. This feature enables the component model to jointly model long-maturity and short-maturity options.

Keywords: Option valuation, long-run component, short-run component, unobserved components, persistence, GARCH, out-of-sample, Volatility term structure

JEL Classification: G12

Suggested Citation

Christoffersen, Peter and Jacobs, Kris and Ornthanalai, Chayawat and Wang, Yintian, Option Valuation with Long-Run and Short-Run Volatility Components (February 18, 2008). Journal of Financial Economics, Vol. 90, No. 3, pp. 272-297; CREATES Research Paper 2008-11. Available at SSRN: https://ssrn.com/abstract=665124 or http://dx.doi.org/10.2139/ssrn.665124

Peter Christoffersen (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5P 3C4
Canada
416-946-5511 (Phone)

HOME PAGE: http://www.christoffersen.com

Copenhagen Business School

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

University of Aarhus - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Kris Jacobs

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Chayawat Ornthanalai

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Yintian Wang

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada

Register to save articles to
your library

Register

Paper statistics

Downloads
1,111
rank
16,552
Abstract Views
4,338
PlumX