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A realized volatility approach to option pricing with continuous and jump variance components

Author

Listed:
  • Dario Alitab

    (Mediobanca S.p.A)

  • Giacomo Bormetti

    (University of Bologna)

  • Fulvio Corsi

    (University of Pisa
    City University London)

  • Adam A. Majewski

    (Capital Fund Management)

Abstract

Stochastic and time-varying volatility models typically fail to correctly price out-of-the-money put options at short maturity. We extend realized volatility option pricing models by adding a jump component which provides a rapidly moving volatility factor and improves on the fitting properties under the physical measure. The change of measure is performed by means of an exponentially affine pricing kernel which depends on an equity and two variance risk premia, associated with the continuous and jump components of realized volatility. Our choice preserves analytical tractability and offers a new way of estimating variance risk premia by combining high-frequency returns and option data in a multicomponent pricing model.

Suggested Citation

  • Dario Alitab & Giacomo Bormetti & Fulvio Corsi & Adam A. Majewski, 2019. "A realized volatility approach to option pricing with continuous and jump variance components," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 42(2), pages 639-664, December.
  • Handle: RePEc:spr:decfin:v:42:y:2019:i:2:d:10.1007_s10203-019-00241-2
    DOI: 10.1007/s10203-019-00241-2
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    Cited by:

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    2. Chorro, Christophe & Ielpo, Florian & Sévi, Benoît, 2020. "The contribution of intraday jumps to forecasting the density of returns," Journal of Economic Dynamics and Control, Elsevier, vol. 113(C).

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    More about this item

    Keywords

    High-frequency; Realized volatility; HARG; Option pricing; Variance risk premium; Jumps;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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