Level and slope of volatility smiles in long-run risk models

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...

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Bibliographic Details
Published in:	Journal of economic dynamics & control Vol. 86; pp. 95 - 122
Main Authors:	Branger, Nicole, Rodrigues, Paulo, Schlag, Christian
Format:	Journal Article
Language:	English
Published:	Elsevier B.V 01-01-2018
Subjects:	Asset pricing Epstein–Zin preferences Jump risk Level and slope of implied volatility smile Stochastic volatility Stochastic volatility G12 Asset pricing Jump risk Level and slope of implied volatility smile Epstein–Zin preferences
Online Access:	Get full text
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Summary:	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.
ISSN:	0165-1889 1879-1743
DOI:	10.1016/j.jedc.2017.10.007