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The Review of Asset Pricing Studies Vol. 8 No. 2 2018

Option Valuation with Volatility Components, Fat Tails, and Nonmonotonic Pricing Kernels*

Kadir Babaoğlu1; Peter Christoffersen2; Steven L. Heston3; Kris Jacobs4

1 RBC Capital Markets · 2 Rotman School of Management, University of Toronto, Copenhagen Business School, and CREATES · 3 Smith School of Business, University of Maryland · 4 Bauer College of Business University of Houston

open access

Abstract

We nest multiple volatility components, fat tails, and a U-shaped pricing kernel in a single option model and compare their contribution in describing returns and option data. All three features lead to statistically significant model improvements. A U-shaped pricing kernel is economically most important and improves option fit by 17%, on average, and more so for two-factor models. A second volatility component improves the option fit by 9%, on average. Fat tails improve option fit by just over 4%, on average, but more so when a U-shaped pricing kernel is applied. Overall, these three model features are complements rather than substitutes: the importance of one feature increases in conjunction with the others.

DOI
10.1093/rapstu/rax021
Volume
8
Issue
2
Pages
183-231
Language
en
Sources
openalex crossref bibtex:phds-export.bib

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