Stock price dynamics and option valuations under volatility feedback effect
According to the volatility feedback effect, an unexpected increase in squared volatility leads to an immediate decline in the price–dividend ratio. In this paper, we consider the properties of stock price dynamics and option valuations under the volatility feedback effect by modeling the joint dyna...
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Veröffentlicht in: | Physica A 2013-02, Vol.392 (4), p.722-740 |
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Format: | Artikel |
Sprache: | eng |
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Zusammenfassung: | According to the volatility feedback effect, an unexpected increase in squared volatility leads to an immediate decline in the price–dividend ratio. In this paper, we consider the properties of stock price dynamics and option valuations under the volatility feedback effect by modeling the joint dynamics of stock price, dividends, and volatility in continuous time. Most importantly, our model predicts the negative effect of an increase in squared return volatility on the value of deep-in-the-money call options and, furthermore, attempts to explain the volatility puzzle. We theoretically demonstrate a mechanism by which the market price of diffusion return risk, or an equity risk-premium, affects option prices and empirically illustrate how to identify that mechanism using forward-looking information on option contracts. Our theoretical and empirical results support the relevance of the volatility feedback effect. Overall, the results indicate that the prevailing practice of ignoring the time-varying dividend yield in option pricing can lead to oversimplification of the stock market dynamics.
► We propose and calibrate a new model to price stocks and options. ► The model assumes the joint dynamics of volatility, dividends, and stock price. ► Our model gives a possible explanation for the volatility puzzle. ► Volatility feedback implies that the equity risk premium affects option prices. ► An increase in volatility can negatively affect the price of call options. |
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ISSN: | 0378-4371 1873-2119 |
DOI: | 10.1016/j.physa.2012.10.004 |