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Asymmetric Smiles, Leverage Effects and Structural Parameters

  • René Garcia

    (Crest)

  • Richard Luger

    (Crest)

  • Eric Renault

    (Crest)

In this paper, we characterize the asymmetries of the smile through multiple leverage effects in a stochastic dynamic asset pricing framework. The dependence between price movements and future volatility is introduced through a set of latent state variables. These latent variables can capture not only the volatility risk and the interest rate risk which potentially affect option prices, but also any kind of correlation risk and jump risk. The standard financial leverage effect is produced by a cross-correlation effect between the state variables which enter into the stochastic volatility process of the stock price and the stock price process itself. However, we provide a more general framework where asymmetric implied volatility curves result from any source of instantaneous correlation between the state variables and either the return on the stock or the stochastic discount factor. In order to draw the shapes of the implied volatility curves generated by a model with latent variables, we specify an equilibrium-based stochastic discount factor with time non-separable preferences. When we calibrate this model to empirically reasonable values of the parameters, we are able to reproduce the various types of implied volatility curves inferred from option market data.

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Paper provided by Centre de Recherche en Economie et Statistique in its series Working Papers with number 2000-57.

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Date of creation: 2000
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Handle: RePEc:crs:wpaper:2000-57
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