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Option Valuation with Volatility Components, Fat Tails, and Nonlinear Pricing Kernels

Author

Listed:
  • Kadir G. Babaoglou

    () (University of Toronto - Rotman School of Management)

  • Peter Christoffersen

    () (University of Toronto - Rotman School of Management and CREATES)

  • Steven L. Heston

    () (University of Maryland - Department of Finance)

  • Kris Jacobs

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

Abstract

We nest multiple volatility components, fat tails and a U-shaped pricing kernel in a single option model and compare their contribution to describing returns and option data. All three features lead to statistically significant model improvements. A second volatility factor is economically most important and improves option fit by 18% on average. A U-shaped pricing kernel improves the option fit by 17% on average, and more so for two-factor models. Fat tails improve option fit by just over 3% on average, and more so when a U-shaped pricing kernel is applied. Our results suggest that the three features we investigate are complements rather than substitutes.

Suggested Citation

  • Kadir G. Babaoglou & Peter Christoffersen & Steven L. Heston & Kris Jacobs, 2014. "Option Valuation with Volatility Components, Fat Tails, and Nonlinear Pricing Kernels," CREATES Research Papers 2015-55, Department of Economics and Business Economics, Aarhus University.
  • Handle: RePEc:aah:create:2015-55
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    File URL: ftp://ftp.econ.au.dk/creates/rp/15/rp15_55.pdf
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    References listed on IDEAS

    as
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    Cited by:

    1. Fengler, Matthias & Melnikov, Alexander, 2017. "GARCH option pricing models with Meixner innovations," Economics Working Paper Series 1702, University of St. Gallen, School of Economics and Political Science.

    More about this item

    Keywords

    volatility components; fat tails; jumps; pricing kernel;

    JEL classification:

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

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