Smile from the past: A general option pricing framework with multiple volatility and leverage components

Abstract

In the current literature, the analytical tractability of discrete time option pricing models is guaranteed only for rather specific types of models and pricing kernels. We propose a very general and fully analytical option pricing framework, encompassing a wide class of discrete time models featuring multiple-component structure in both volatility and leverage, and a flexible pricing kernel with multiple risk premia. Although the proposed framework is general enough to include either GARCH-type volatility, Realized Volatility or a combination of the two, in this paper we focus on realized volatility option pricing models by extending the Heterogeneous Autoregressive Gamma (HARG) model of Corsi et al. (2013) to incorporate heterogeneous leverage structures with multiple components, while preserving closed-form solutions for option prices. Applying our analytically tractable asymmetric HARG model to a large sample of S&P 500 index options, we demonstrate its superior ability to price out-of-the-money options compared to existing benchmarks.