Fanning Out Preference and Option Pricing
As is well known, the major critique on Black-Scholes model is its failure to explain the volatility smirk observed in the real financial market. To better price the cross-sectional index options, a vast literature suggests more general models incorporating the stochastic volatility and the jump (see, for example, (Bates (1996). Review of Financial Studies 9, 69–108, Bates (2000). Journal of Econometrics 94, 181–238, Bakshi, Cao and Chen (1997). Journal of Finance 52, 2003–2049, Pan (2002). Journal of Financial Economics 63, 3–50, Huang and Wu (2004). Journal of Finance 59, 1405–1439, Carr and Wu (2004). Journal of Financial Economics 71, 113–141 and Santa-Clara and Yan (2010). The Review of Economics and Statistics 92, 435–451.) (Bates 1996, 2000; Bakshi et al. 1997; Pan 2002; Huang and Wu 2004; Carr and Wu 2004; Santa-Clara and Yan 2010)). These previous papers, however, price options under a partial equilibrium framework and assume an underlying return dynamics given exogenously.