Journal
REVIEW OF FINANCIAL STUDIES
Volume 26, Issue 8, Pages 1963-2006Publisher
OXFORD UNIV PRESS INC
DOI: 10.1093/rfs/hht033
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We develop a GARCH option model with a new pricing kernel allowing for a variance premium. While the pricing kernel is monotonic in the stock return and in variance, its projection onto the stock return is nonmonotonic. A negative variance premium makes it U shaped. We present new semiparametric evidence to confirm this U-shaped relationship between the risk-neutral and physical probability densities. The new pricing kernel substantially improves our ability to reconcile the time-series properties of stock returns with the cross-section of option prices. It provides a unified explanation for the implied volatility puzzle, the overreaction of long-term options to changes in short-term variance, and the fat tails of the risk-neutral return distribution relative to the physical distribution.
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