Level and Slope of Volatility Smiles in Long-Run Risk Models

98 Pages Posted: 6 Nov 2017 Last revised: 14 Dec 2017

See all articles by Nicole Branger

Nicole Branger

University of Muenster - Finance Center Muenster

Paulo Rodrigues

Maastricht University - Department of Finance

Christian Schlag

Goethe University Frankfurt; Leibniz Institute for Financial Research SAFE

Date Written: November 3, 2017

Abstract

We propose a long-run risk model with stochastic volatility, a time-varying mean reversion level of volatility, and jumps in the state variables. The special feature of our model is that the jump intensity is not affine in the conditional variance but driven by a separate process. We show that this separation of jump risk from volatility risk is needed to match the empirically weak link between the level and the slope of the implied volatility smile for S&P 500 options.

Keywords: Asset pricing, Epstein-Zin preferences, jump risk, stochastic volatility, level and slope of implied volatility smile

JEL Classification: G12

Suggested Citation

Branger, Nicole and Rodrigues, Paulo and Schlag, Christian, Level and Slope of Volatility Smiles in Long-Run Risk Models (November 3, 2017). SAFE Working Paper No. 186, Available at SSRN: https://ssrn.com/abstract=3064658 or http://dx.doi.org/10.2139/ssrn.3064658

Nicole Branger

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany
+49 251 83 29779 (Phone)
+49 251 83 22867 (Fax)

HOME PAGE: http://www.wiwi.uni-muenster.de/fcm/fcm/das-finance-center/details.php?weobjectID=162

Paulo Rodrigues

Maastricht University - Department of Finance ( email )

Maastricht, 6200 MD
Netherlands

Christian Schlag (Contact Author)

Goethe University Frankfurt ( email )

Faculty of Economics and Business
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, Hessen 60323
Germany

Leibniz Institute for Financial Research SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany
+49 69 798 33699 (Phone)

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