Working Paper

Option prices with uncertain fundamentals theory and evidence on the dynamics of implied volatilities

Abstract: In an incomplete information model, investors' uncertainty about the underlying drift rate of a firm's fundamentals affects option prices through (i) endogenous and belief-dependent stochastic volatility, (ii) stochastic covariance between returns and volatility, and (iii) a market price of \"belief risk.\" For the special case where the drift takes only two values, we provide an option pricing formula using Fourier Transforms. The model calibrated to 1960-1998 S&P 500 real earnings growth shows that investors' uncertainty explains intertemporal variation in the slope and curvature of implied volatility curves as well as the conditional moments of the state-return density obtained from option data. The calibrated model generates hedging `violations' of one-factor markov and deterministic volatility function models with roughly empirical frequencies.

Keywords: options; Stock - Prices;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 1999

Number: 1999-47