Capturing Option Anomalies with a Variance-Dependent Pricing Kernel

Peter Christoffersen; Steven L. Heston; Kris Jacobs

doi:10.1093/rfs/hht033

Capturing Option Anomalies with a Variance-Dependent Pricing Kernel

Peter Christoffersen^1,2; Steven L. Heston³; Kris Jacobs^4,5

¹ Copenhagen Business School · ² University of Toronto · ³ University of Maryland, College Park · ⁴ Tilburg University · ⁵ University of Houston

Review of Financial Studies 2013

We develop a GARCH option model with a new pricing kernel allowing for a variance premium. While the pricing kernel is monotonic in the stock return and in variance, its projection onto the stock return is nonmonotonic. A negative variance premium makes it U shaped. We present new semiparametric evidence to confirm this U-shaped relationship between the risk-neutral and physical probability densities. The new pricing kernel substantially improves our ability to reconcile the time-series properties of stock returns with the cross-section of option prices. It provides a unified explanation for the implied volatility puzzle, the overreaction of long-term options to changes in short-term variance, and the fat tails of the risk-neutral return distribution relative to the physical distribution. The Author 2013. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

DOI: 10.1093/rfs/hht033
Volume: 26 (8)
Pages: 1963-2006
Language: en
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