Option Prices with Uncertain Fundamentals: Theory and Evidence on the Dynamics of Implied Volatilities

64 Pages Posted: 17 Feb 2000

See all articles by Alexander David

Alexander David

Haskayne School of Business, University of Calgary; University of Calgary - Haskayne School of Business

Pietro Veronesi

University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: November 2000

Abstract

In an imcomplete information model, we show that investors' uncertainty about the drift of a firm's fundamentals affects option prices through its affect on stock volatility and the covariance between returns and volatility. We provide an option pricing formula using Fourier Transforms. Filtered investor beliefs from real earnings growth are able to explain time-variation in implied volatility, the skewness premium, and the kurtosis premium embedded in option prices. Option-implied investor beliefs vacillated rapidly before the crash of 1987, remained highly uncertain for a year afterwards, and except for the 1990-91 recession, strongly favored rapid growth until 1996. Model fits to cross-sectional option prices are almost comparable to Heston's (1993) stochastic volatility model while hedging and variance forecasting performance is superior.

JEL Classification: G12, G13, G14, D84

Suggested Citation

David, Alexander and Veronesi, Pietro, Option Prices with Uncertain Fundamentals: Theory and Evidence on the Dynamics of Implied Volatilities (November 2000). Available at SSRN: https://ssrn.com/abstract=199332 or http://dx.doi.org/10.2139/ssrn.199332

Alexander David (Contact Author)

Haskayne School of Business, University of Calgary ( email )

2500 University Drive NW
Calgary, Alberta T2N1N4
Canada
403-220-6987 (Phone)

University of Calgary - Haskayne School of Business ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
Canada

Pietro Veronesi

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-6348 (Phone)
773-702-0458 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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