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Option Valuation with Macro-Finance Variables

Published online by Cambridge University Press:  01 November 2016

Christian Dorion
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Abstract

I propose a model in which the price of an option is partly determined by macro-finance variables. In an application using an index of current business conditions, the new model outperforms existing benchmarks in fitting underlying asset returns and in pricing options. The model performs particularly well when business conditions are deteriorating. Using the recent financial crisis as an out-of-sample experiment, the new model has option-pricing errors that are 18% below those of a nested 2-component volatility benchmark. Results are robust to using alternative business conditions proxies and comparing to different benchmark models.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 51 , Issue 4 , August 2016 , pp. 1359 - 1389
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2016 

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