EFFECTS OF RETURN PREDICTABILITY ON OPTION PRICES WITH STOCHASTIC VOLATILITY FOR THE MARKET PORTFOLIO

Abstract

I examine the effects of return predictability on option prices for the market portfolio in the presence of stochastic volatility and/or stochastic interest rates. The analysis is implemented in an equilibrium framework where a consistent option pricing model is derived with the return predictability and stochastic volatility and the precise link between the actual and the risk neutral measures is endogenized. The equilibrium analysis indicates that the return predictability is induced by the mean-reverting and heteroskedastic features of aggregate dividends. It is shown that risk-neutral option pricing model with the stochastic volatility and/or stochastic interest rates can be consistent with return predictability. Numerical results suggest that (i) models with either perfect predictability or no predictability will significantly overprice long-term options across different strike prices when the return of the underlying exhibits modest predictability; (ii) the stochastic volatility does not affect option prices in a significant way when asset return predictability is properly reflected in the actual stock price process; (iii) when return predictability is correctly specified, the effects of stochastic interest rates are not uniform.