Option valuation with conditional skewness

Index option prices differ systematically from Black-Scholes prices. Out-of-the-money put prices (and in-the-money call prices) are relatively high compared to the Black-Scholes price. Motivated by these empirical facts, we develop a new discrete-time dynamic model of stock returns with inverse Gaussian innovations. The model allows for conditional skewness as well as conditional heteroskedasticity and a leverage effect. We present all analytic option pricing formula consistent with this stock return dynamic. Ail extensive empirical test of the model using S&P500 index options shows that the new inverse Gaussian GARCH model's performance is superior to a standard existing nested model for out-of-the money Puts. (c) 2005 Elsevier B.V. All rights reserved.