Option Pricing with State-dependent Pricing Kernel
Pricing of Securities
2022-04-15 v2 Econometrics
Abstract
We introduce a new volatility model for option pricing that combines Markov switching with the Realized GARCH framework. This leads to a novel pricing kernel with a state-dependent variance risk premium and a pricing formula for European options, which is derived with an analytical approximation method. We apply the Markov switching Realized GARCH model to S&P 500 index options from 1990 to 2019 and find that investors' aversion to volatility-specific risk is time-varying. The proposed framework outperforms competing models and reduces (in-sample and out-of-sample) option pricing errors by 15% or more.
Cite
@article{arxiv.2112.05308,
title = {Option Pricing with State-dependent Pricing Kernel},
author = {Chen Tong and Peter Reinhard Hansen and Zhuo Huang},
journal= {arXiv preprint arXiv:2112.05308},
year = {2022}
}