Department of Economics and Business Economics

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

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  • Kadir G. Babaglou, University of Toronto, Canada
  • Peter Christoffersen, University of Toronto and CREATES, Canada
  • Stefen L. Heston, University of Maryland, United States
  • Kris Jacobs, Universitiy of Houston, United States
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.
Original languageEnglish
Place of publicationAarhus
PublisherInstitut for Økonomi, Aarhus Universitet
Number of pages50
Publication statusPublished - 30 Nov 2015
SeriesCREATES Research Papers
Number2015-55

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