Events

Author:

• Mr. Du DU
  University of Chicago

This paper demonstrates a new parsimonious structural model, estimated using the method of simulated moments (MSM) based on the joint data of stocks and options, which explains well the observed unconditional and conditional volatility smirks in option pricing. The driving forces are a slow moving external habit and i.i.d. consumption jumps which induce jumps in stock prices. Habit formation generates the excess volatility which is tightly linked to price levels of ATM (at-the-money) options quoted in terms of Black-Scholes implied volatility (B/S-vol), while jumps generate the observed variations in B/S-vol across varying degrees of moneyness. The model also has predictions about the term structure of option pricing, historical smirk premia backed out of historical consumption, and a wide variety of stock pricing features which are all veri_ed by the data. The model's implications are robust for more realistic assumptions about the dividend process.