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arXiv · 2112.05308

Option Pricing with State-dependent Pricing Kernel

Chen Tong·Peter Reinhard Hansen·Zhuo Huang
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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.

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Chen Tong, Peter Reinhard Hansen, Zhuo Huang. 2021-12-10. Option Pricing with State-dependent Pricing Kernel. https://arxiv.org/abs/2112.05308

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