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Option Valuation with Macro-Finance Variables

  • Christian Dorion

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.

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Corresponding author

* Dorion (corresponding author), christian.dorion@hec.ca, HEC Montréal, Montréal QC H3T 2A7, Canada.

References

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