Abstract
Abstract Index option prices differ systematically from Black–Scholes prices. Out-of-the-money put prices (and in-the-money call prices) are relatively high compared to the Black–Scholes price. Motivated by these empirical facts, we develop a new discrete-time dynamic model of stock returns with inverse Gaussian innovations. The model allows for conditional skewness as well as conditional heteroskedasticity and a leverage effect. We present an analytic option pricing formula consistent with this stock return dynamic. An extensive empirical test of the model using S&P500 index options shows that the new inverse Gaussian GARCH model's performance is superior to a standard existing nested model for out-of-the money puts.
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