Does variance risk have two prices? Evidence from the equity and option markets. Working Paper

Abstract We formally compare two versions of the market variance risk premium (VRP) measured in the equity and option markets. Both VRPs follow common patterns and respond similarly to changes in volatility and economic conditions. However, we reject the null hypothesis that they are identical and …nd that their di¤erence is strongly related to measures of the …nancial standing of intermediaries. These results shed new light on the information content of the VRP, suggest the presence of market frictions between the two markets, and are consistent with the key role played by intermediaries in setting option prices. JEL classi…cation: G12, G13, C5

A Multivariate Stochastic Unit Root Model with an Application to Derivative Pricing

This paper extends recent findings of Lieberman and Phillips (2014) on stochastic unit root (SUR) models to a multivariate case including a comprehensive asymptotic theory for estimation of the model’s parameters. The extensions are useful because they lead to a generalization of the Black-Scholes formula for derivative pricing. In place of the standard assumption that the price process follows a geometric Brownian motion, we derive a new form of the Black-Scholes equation that allows for a multivariate time varying coefficient element in the price equation. The corresponding formula for the value of a European-type call option is obtained and shown to extend the existing option price formula in a manner that embodies the effect of a stochastic departure from a unit root. An empirical application reveals that the new model is consistent with excess skewness and kurtosis in the price distribution relative to a lognormal distribution