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Jump variance risk: Evidence from option valuation and stock returns |
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| Authors: | Hsuan-Ling Chang Yen-Cheng Chang Hung-Wen Cheng Po-Hsiang Peng Kevin Tseng |
| Affiliation: | 1. Department of Finance, National Taiwan University, Taipei, Taiwan;2. Department of Financial Engineering and Actuarial Mathematics, Soochow University, Taipei, Taiwan;3. Institute of Statistics, National Tsing Hua University, Hsinchu, Taiwan;4. School of Business, University of Kansas, Lawrence, Kansas |
| Abstract: | We study jump variance risk by jointly examining both stock and option markets. We develop a GARCH option pricing model with jump variance dynamics and a nonmonotonic pricing kernel featuring jump variance risk premium. The model yields a closed-form option pricing formula and improves in fitting index options from 1996 to 2015. The model-implied jump variance risk premium has predictive power for future market returns. In the cross-section, heterogeneity in exposures to jump variance risk leads to a 6% difference in risk-adjusted returns annually. |
| Keywords: | jump variance risk nonmonotonic pricing kernel option valuation return predictability |