Riccardo Faini CEIS Seminars

Structural Stochastic Volatility
November, 20th 2020 (16:00-17:00)
TEAMS Webinar – Registration required

Federico Maria Bandi (Johns Hopkins University)

Riccardo Faini CEIS Webinars

Registration form - no later than Thursday

joint with Nicola Fusari and Roberto Renò

We use an approximation to the characteristic function of the equity process in continuous time to derive a broadly-applicable option pricing formula. The formula, along with option data, is employed to jointly identify equity characteristics (spot volatility, spot leverage and spot volatility of volatility) which have been the focus of separate strands of the literature. We show that the proposed identification method yields measurements which are statistically accurate and economically informative. Because equity is a call option on asset values, all equity characteristics should depend on fundamental state variables, such as the variance of the firm’s assets and the extent of the firm’s financial leverage. Among other findings, consistent with economic logic, we report a strong link between spot leverage (the generally-negative correlation between equity returns and spot volatility) and financial leverage (the firm’s debt-to-equity ratio), a relation invariably found to be elusive in the data. We conclude that the economic content of option-implied measurements can be put to work to understand the structural drivers of equity (and debt) dynamics from a novel vantage point.