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Option-implied term structures


Abstract: This paper proposes a nonparametric sieve regression framework for pricing the term structure of option spanning portfolios. The framework delivers closed-form, nonparametric option pricing and hedging formulas through basis function expansions that grow with the sample size. Novel confidence intervals quantify term structure estimation uncertainty. The framework is applied to estimating the term structure of variance risk premia and finds that a short-run component dominates market excess return predictability. This finding is inconsistent with existing asset pricing models that seek to explain the variance risk premium?s predictive content.

Keywords: variance risk premium; term structures; options; return predictability; nonparametric regression;

JEL Classification: C58; G12; G17;

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Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2016-01-01

Number: 706