Capturing Option Anomalies with a Variance-Dependent Pricing Kernel
Abstract
In collaboration with Prof Steve Heston (University of Maryland) and Prof Kris Jacobs (University of Houston), the speaker develops a GARCH option model with a variance premium by combining the Heston-Nandi (2000) dynamic with a new pricing kernel that nests Rubinstein (1976) and Brennan (1979). While the pricing kernel is monotonic in the stock return and in variance, its projection onto the stock return is nonmonotonic. A negative variance premium makes it U-shaped. The speaker presents new semi-parametric evidence to con firm this U-shaped relationship between the risk-neutral and physical probability densities. The new pricing kernel substantially improves our ability to reconcile the time series properties of stock returns with the cross-section of option prices. It provides a unifi ed explanation for the implied volatility puzzle, the overreaction of long-term options to changes in short-term variance, and the fat tails of the risk-neutral return distribution relative to the physical distribution.
About the speaker
Prof. Peter Christoffersen is a Professor of Finance at the Rotman School of Management at the University of Toronto. He is the author of Elements of Financial Risk Management and his research articles have been published in a number of leading finance and econometrics journals. He is currently an associate editor of the Review of Financial Studies, Journal of Applied Econometrics, the Journal of Financial Econometrics, and the Journal of Risk. He has won research awards from the Q-Group, KPMG, the Montreal Exchange, and STOXX. He has given invited lectures at the Bank of America, the Bank of Canada, the European Central Bank, the Board of Governors of the Federal Reserve, and the International Monetary Fund among others. Before joining the Rotman School in 2010 he taught at McGill University and worked as an economist at the International Monetary Fund in Washington, DC. He is also affiliated with the Copenhagen Business School and with CREATES. Further information about Prof Christoffersen is available on the web at www.christoffersen.com.
