Abstract
We study the equity premium and option pricing under jump-diffusion model with stochastic volatility based on the model in Zhang et al. 2012. We obtain the pricing kernel which acts like the physical and risk-neutral densities and the moments in the economy. Moreover, the exact expression of option valuation is derived by the Fourier transformation method. We also discuss the relationship of central moments between the physical measure and the risk-neutral measure. Our numerical results show that our model is more realistic than the previous model.
Highlights
Option pricing problem is one of the predominant concerns in the financial market
We get the relationship of central moments between the physical measure and the risk-neutral measure which can help us to study the negative variance risk premium, the implied volatility smirk, and the prediction of realized skewness
The equity premium is very important for option pricing in general equilibrium framework
Summary
Option pricing problem is one of the predominant concerns in the financial market. Since the advent of the Black-Scholes option pricing formula in [1], there has been an increasing amount of literature describing the theory and its practice. We build a general equilibrium model which is the same as that due to Santa-Clara and Yan (2004) [12] Under this model, we obtain an exact expression of the equity premium and the pricing kernel in a general equilibrium economy. We obtain an exact expression of the equity premium and the pricing kernel in a general equilibrium economy This can be regarded as a great contribution to the literature. Abstract and Applied Analysis constant volatility models with jump diffusions, Pan (2002), Liu and Pan (2003), and Liu et al (2005) [35,36,37] derived the pricing kernel with some restrictions of jump sizes in a general equilibrium setting.
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