Asset Variance Risk and Compound Option Prices

54 Pages Posted: 14 Jul 2021

See all articles by Hitesh Doshi

Hitesh Doshi

University of Houston - C.T. Bauer College of Business

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Mathieu Fournier

HEC Montreal

Sang Byung Seo

University of Wisconsin - Madison

Date Written: July 13, 2021

Abstract

We evaluate the empirical validity of the compound option framework. In a model where corporate securities are options on a firm's assets, option contracts on these can be viewed as options on options, or compound options. We estimate a model with priced asset variance risk and find that it jointly explains the level and time variation of both equity index (SPX) and credit index (CDX) option prices well out-of-sample. This suggests that the two options markets are priced consistently, contrary to recent findings. We show that variance risk is important for establishing pricing consistency between equity, credit, and related derivatives.

JEL Classification: G12, G13

Suggested Citation

Doshi, Hitesh and Ericsson, Jan and Fournier, Mathieu and Seo, Sang Byung, Asset Variance Risk and Compound Option Prices (July 13, 2021). Available at SSRN: https://ssrn.com/abstract=3885357 or http://dx.doi.org/10.2139/ssrn.3885357

Hitesh Doshi

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Jan Ericsson (Contact Author)

McGill University ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
(514) 398-3186 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://people.mcgill.ca/jan.ericsson/

Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

Mathieu Fournier

HEC Montreal ( email )

3000, Chemin de la Côte-Sainte-Catherine
Montreal, Quebec H2X 2L3 H3T 2A7
Canada

Sang Byung Seo

University of Wisconsin - Madison ( email )

975 University Avenue
Madison, WI 53706-1324

HOME PAGE: http://sites.google.com/site/sangbyungseo

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