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Stock Price Dynamics and Option Valuations under Volatility Feedback Effect

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Stock Price Dynamics and Option Valuations under Volatility Feedback Effect. / Kanniainen, Juho; Piche, Robert.

In: Physica A: Statistical Mechanics and Its Applications, Vol. 392, No. 4, 2013, p. 722-740.

Research output: Contribution to journalArticleScientificpeer-review

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Kanniainen, J & Piche, R 2013, 'Stock Price Dynamics and Option Valuations under Volatility Feedback Effect', Physica A: Statistical Mechanics and Its Applications, vol. 392, no. 4, pp. 722-740. https://doi.org/10.1016/j.physa.2012.10.004

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Kanniainen, Juho ; Piche, Robert. / Stock Price Dynamics and Option Valuations under Volatility Feedback Effect. In: Physica A: Statistical Mechanics and Its Applications. 2013 ; Vol. 392, No. 4. pp. 722-740.

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@article{104dfd391f424f8eb7e1bd56270fbd4e,
title = "Stock Price Dynamics and Option Valuations under Volatility Feedback Effect",
abstract = "According to the volatility feedback effect, an unexpected increase in squared volatility leads to an immediate decline in the price-dividend ratio. In this paper, we consider the properties of stock price dynamics and option valuations under the volatility feedback effect by modeling the joint dynamics of stock price, dividends, and volatility in continuous time. Most importantly, our model predicts the negative effect of an increase in squared return volatility on the value of deep-in-the-money call options and, furthermore, attempts to explain the volatility puzzle. We theoretically demonstrate a mechanism by which the market price of diffusion return risk, or an equity risk-premium, affects option prices and empirically illustrate how to identify that mechanism using forward-looking information on option contracts. Our theoretical and empirical results support the relevance of the volatility feedback effect. Overall, the results indicate that the prevailing practice of ignoring the time-varying dividend yield in option pricing can lead to oversimplification of the stock market dynamics.",
author = "Juho Kanniainen and Robert Piche",
note = "Tallennettu Online First 2012:na.Final version published online 22 Dec 2012<br/>Contribution: organisation=tta,FACT1=0.8<br/>Contribution: organisation=mat,FACT2=0.2<br/>Publisher name: Elsevier",
year = "2013",
doi = "10.1016/j.physa.2012.10.004",
language = "English",
volume = "392",
pages = "722--740",
journal = "Physica A: Statistical Mechanics and Its Applications",
issn = "0378-4371",
publisher = "Elsevier",
number = "4",

}

RIS (suitable for import to EndNote) - Download

TY - JOUR

T1 - Stock Price Dynamics and Option Valuations under Volatility Feedback Effect

AU - Kanniainen, Juho

AU - Piche, Robert

N1 - Tallennettu Online First 2012:na.Final version published online 22 Dec 2012<br/>Contribution: organisation=tta,FACT1=0.8<br/>Contribution: organisation=mat,FACT2=0.2<br/>Publisher name: Elsevier

PY - 2013

Y1 - 2013

N2 - According to the volatility feedback effect, an unexpected increase in squared volatility leads to an immediate decline in the price-dividend ratio. In this paper, we consider the properties of stock price dynamics and option valuations under the volatility feedback effect by modeling the joint dynamics of stock price, dividends, and volatility in continuous time. Most importantly, our model predicts the negative effect of an increase in squared return volatility on the value of deep-in-the-money call options and, furthermore, attempts to explain the volatility puzzle. We theoretically demonstrate a mechanism by which the market price of diffusion return risk, or an equity risk-premium, affects option prices and empirically illustrate how to identify that mechanism using forward-looking information on option contracts. Our theoretical and empirical results support the relevance of the volatility feedback effect. Overall, the results indicate that the prevailing practice of ignoring the time-varying dividend yield in option pricing can lead to oversimplification of the stock market dynamics.

AB - According to the volatility feedback effect, an unexpected increase in squared volatility leads to an immediate decline in the price-dividend ratio. In this paper, we consider the properties of stock price dynamics and option valuations under the volatility feedback effect by modeling the joint dynamics of stock price, dividends, and volatility in continuous time. Most importantly, our model predicts the negative effect of an increase in squared return volatility on the value of deep-in-the-money call options and, furthermore, attempts to explain the volatility puzzle. We theoretically demonstrate a mechanism by which the market price of diffusion return risk, or an equity risk-premium, affects option prices and empirically illustrate how to identify that mechanism using forward-looking information on option contracts. Our theoretical and empirical results support the relevance of the volatility feedback effect. Overall, the results indicate that the prevailing practice of ignoring the time-varying dividend yield in option pricing can lead to oversimplification of the stock market dynamics.

U2 - 10.1016/j.physa.2012.10.004

DO - 10.1016/j.physa.2012.10.004

M3 - Article

VL - 392

SP - 722

EP - 740

JO - Physica A: Statistical Mechanics and Its Applications

JF - Physica A: Statistical Mechanics and Its Applications

SN - 0378-4371

IS - 4

ER -