TIME SERIES ANALYSIS OF OPTION

PRICING MODELS PERFORMANCE

MASTER THESIS IN FINANCE
Mal Hartl (6060929)


Supervisor: Gildas Blanchard
School of Business and Economics
January 2014

1

Acknowledgements

When I started this thesis in June 2013, it was a rather ambitious project,
considering that my knowledge of option pricing models was limited to a vague
understanding of the Black-Scholes equations. Six months of continuous work
later, I must say I am rather impressed by all the things this thesis has taught me. I
would like to address my gratitude to my thesis supervisor, Gildas Blanchard, for
his constant availability, patient guidance and helpful remarks during the writing
of this report. Although I take full credit for the results presented below, they were
the fruit of a continuous exchange of ideas between Gildas and I must thank him
for keeping my eye on the prize. I also thank my family and close ones for their
help and support.


2

Table of Contents
INTRODUCTION .......................................................................................................................... 4
EMPIRICAL METHODOLOGY ................................................................................................... 6
DESCRIPTION OF THE DATA ..................................................................................................................... 6
Option data ................................................................................................................................................ 6
Index data ................................................................................................................................................... 9
OPTION PRICING MODELS ..................................................................................................................... 10
Ad-hoc Black and Scholes model ................................................................................................... 10
Heston and Nandi GARH !odel ................................................................................................... 11
Reasons "o# choosin$ the ABS and HN models ........................................................................ 1%
CALIBRATION .......................................................................................................................................... 14
ABS p#oced&#e ........................................................................................................................................ 1'
HN-GARH model ................................................................................................................................. 1(
EMPIRICAL RESULTS ...............................................................................................................16
I. OPTION PRICING PERFORMANCE OF THE MODELS ........................................................................ 17
In-sample model pe#"o#mance ........................................................................................................ 1)
In-sample pe#"o#mance ac#oss mat&#it* and mone*ness cate$o#ies ........................... +1
O&t-o"-sample model pe#"o#mance ............................................................................................... +%
II. FACTORS OF OPTION PRICING PERFORMANCE .............................................................................. 24
,o#e-o#d .................................................................................................................................................. +'
Stationa#it* and &nit #oot testin$ ................................................................................................. +'
ommon t#ends amon$ ABS and HN p#icin$ e##o#s ............................................................. +(
.##o# "o#ecastin$ /a#ia0les .............................................................................................................. +6
In-sample time se#ies #e$#ession "o# the ABS model ............................................................ %1
In sample #e$#essions "o# the HN GARH model .................................................................... %1
O&t-o"-sample time se#ies #e$#ession "o# the ABS and HN model .................................. '1
CONCLUSIONS ............................................................................................................................47
REFERENCES ..............................................................................................................................50
APPENDIX ...................................................................................................................................53


3

List of figures
Figure 1: S&P 500 index level (Wednesdays only), daily log-returns and
autocorrelation of squared returns .................................................................... 9
Figure 2: Calibration of the ABS model on the cross-section of OTM options on
June 16th 2010 and smoothed volatility surface ............................................ 15
Figure 3: Weekly VIX Index level (Jan. 1996 - June 2010 .................................... 16
Figure 4: Calibration of the HN GARCH model on the cross-section of OTM SPX
options on Jan. 17th, 1996 .............................................................................. 16
Figure 5: Time series of the in-sample option pricing performance (January 17
th
,
1996- June 30
th
, 2010) .................................................................................... 17
Figure 6: Comparison between the original DFW procedure and the HN GARCH
model .............................................................................................................. 19
Figure 7: Comparison of the pricing error across moneyness and maturity
categories for the HN and ABS models ......................................................... 22
Figure 8: Out-of-sample pricing errors of the HN and ABS models ..................... 23
Figure 9: Autocorrelations and XCF function of first-differenced $RMSE series
for ABS and HN ............................................................................................. 25
Figure 10: Autocorrelations and XCF function of original $RMSE series for ABS
and HN............................................................................................................ 25
Figure 11: Zero curve interpolation, yield spread and option pricing error ........... 34
Figure 12: Dividend yield and pricing error ........................................................... 37
Figure 13: Illustration of the distortions created by abnormal demand for "crash-
protective" puts ............................................................................................... 39

List of tables
Table 1: Sample periods covered across option price studies .................................. 6
Table 2: Results of the filtering process ................................................................... 7
Table 3: Description of the option data .................................................................... 8
Table 4: Calibration of the HN GARCH and ABS pricing models ....................... 18
Table 5: In sample regressions for ABS pricing errors (filtered sample of OTM
options) ........................................................................................................... 32
Table 6: In sample regressions for HN pricing error (filtered sample of OTM
options) ........................................................................................................... 39
Table 7: Out of sample regressions for ABS pricing errors (filtered sample of
OTM options) ................................................................................................. 43
Table 8: Out of sample regressions for HN pricing errors (filtered sample of OTM
options) ........................................................................................................... 44


4

Introduction
Since the creation of the first listed option exchange in 1973, the market for stock
options has grown at an incredibly rapid pace. From 911 contracts on the opening
day of the Chicago Board Options Exchange in 1973, the daily average volume
increased to an impressive 4.25 million contracts in 2013, with more than 800,000
options traded daily on the S&P 500 index. Every trading day, thousands of
market participants rely on various option pricing models to compete on this
formidable marketplace.

Along with this dramatic growth, the last forty years have also witnessed the birth
and flourishing of an option pricing literature, initiated by Fischer Black and
Myron Scholes pioneering article in 1973. Since then, academics have worked
relentlessly on developing ever more performing option pricing models, either by
relaxing the assumptions of the Black-Scholes formula to fit the so-called
volatility smile, or by creating alternative models improving the fit on the prices
observed on the market. Examples include the binomial model of Cox, Ross and
Rubinstein (1979), the stochastic volatility model of Heston (1993) and the
deterministic volatility model of Dumas, Fleming and Whaley (1998). The steady
increase in processor computational power has been accompanied by the
emergence of increasingly complex option valuation models, to the point that
recent models price options with a remarkable accuracy most of the time.

Although the literature has achieved a great deal by developing and comparing a
large number of pricing models, it has consistently neglected one aspect: the time
series behavior of option pricing performance. As said, most modern models
usually achieve a good level of performance. However, observing option pricing
performance over longer periods leads to a common conclusion for all models:
performance is not constant over time and it appears to follow some form of
cyclical pattern. This thesis addresses this gap in the existing literature by studying
the time-series of option pricing performance for two widely accepted models, the
ad hoc Black and Scholes, or practitioners model, and the Heston and Nandi
GARCH model with Gaussian innovations. For our study, we rely on fourteen
years of data on S&P 500 index options from 1996 to 2010. This long time frame
allows us to capture long-run trends in valuation performance that might be
overlooked over shorter horizons, such as the two- or three-year sample periods
usually found in the option pricing literature. It also allows us to observe the
effects of the two most recent financial crises.

Our empirical research consists of two parts. We first derive the time series of the
pricing error by calibrating our two models on our sample of option data, and we
show that our results support the hypothesis of a cyclical pattern in option pricing
performance. In a second part, we then review the literature to construct a set of
economic factors that could explain the time series behavior of the option pricing
error. Using this set of explanatory variables, we then document that upward and
downward movements in pricing performance can be explained by changes in the
overall economic environment.



5

For both our models, our results unambiguously show that the level of mispricing
on index options considerably increases with worsening financial market
conditions. Specifically, our research shows that the level of error grows along
with declining dividend yields, fluctuations in short-term interest rates and yield
spread, decreasing price to book ratios and sentiment drops among institutional
investors. We document that, as economic conditions deteriorate, gradually
booming demand for crash-protective put options induces distorted implied
volatility surfaces and high period-to-period volatility for the pricing model
parameters, which ultimately lead to degraded pricing performance. Moreover, we
show that these results are consistent across models and that they hold for in- and
out-of-sample valuation. To the extent of our knowledge, this is the first piece of
evidence of a direct relationship between option pricing error and financial market
conditions. Our research therefore allows a better understanding of the factors that
drive option-pricing performance. It marks a first step toward answering the until
now unaddressed question: What explains the ups and downs in option valuation
accuracy over time?

This thesis is organized as follows. In the first section, we describe our sample of
option and index data, we summarize the theory behind our option pricing models,
and we briefly explain our calibration procedure. In the second section, we present
our empirical results. We first describe the time series of valuation errors for the
ad hoc Black and Scholes and Heston and Nandi models and argue that they
follow cyclical trends. We then turn to time series regressions to identify the
determinants of this common periodic trend. In the last section, we conclude and
review the various ways to improve and extend our study.


6

Empirical methodology
In this section, we provide an overview of the data, methodology and option
pricing theory we use to obtain our empirical results. We first describe our sample
of option and index data and then proceed to develop the theoretical framework
underlying the two option pricing models we rely on in this research: the ad-hoc
Black-Scholes (ABS) model and the Heston and Nandi GARCH model (HN).
Next, we provide the motivations for choosing these two models in particular.
Finally, we briefly describe the calibration of the two option pricing models on the
sample of option data.
Description of the data
Option data
We use intra-day data on European SPX options to test our models and compute
the two time series of the dollar root mean square error ($RHSE). We consider
closing prices of out-of-the-money (OTM) put and call options downloaded from
OptionMetrics for each Wednesday from January 17
th
, 1996 to June 31, 2010
1
,
resulting in 263,127 observations (126,555 calls and 136,572 puts). Note that we
choose to exclude ITM and DITM put and call options from our sample to limit
the risk of having our results driven by liquidity biases. As Alexander (2008)
points out, ITM options behave more like the underlying asset than OTM options,
and are therefore a less viable hedging tool for portfolio managers, who are less
interested in trading them. Another important remark is that the sample period we
consider in our study is significantly longer that those usually covered in the
option pricing literature, as Table 1 points out. By choosing longer time series of
option and index records, we unavoidably increase the computational burden
associated with the calibration process. However, we also expect to capture
longer-term dynamic movements of this error that might be overlooked or difficult
to observe over shorter periods.
Table 1: Sample periods covered across option price studies
Study SPX options data Sample period covered
Barone-Adesi, Engle and Mancini (2008) Wednesdays only Jan. 2002-Dec. 2004
Christoffersen and Jacobs (2004) Wednesdays only Jun. 1988-Jun. 1991
Heston and Nandi (2000) Wednesdays only Jan. 1992-Dec. 1994
Dumas, Fleming and Whaley (1998) Wednesdays only Jun. 1988-Dec. 1993
As we noted earlier, we decide to follow common practice and restrict our
research to Wednesday only data, because it allows us to study longer time series
for the pricing error. For our empirical setup, the weekly data criterion leaves us
with 754 days of option data. Time series for daily data have also been studied for
some sub-periods and are available upon request. However, working with daily
data considerably increases the size of the total sample and renders the calibration

1
Due to stock market holidays and dramatic events such as 9/11, the CBOE trading floor was
closed for eight Wednesdays in our sample. Data for the subsequent trading day is used in the case
of missing Wednesdays. Since the stock market was closed from Tuesday 09/11/2001 to Monday
11/17/2001, we have a missing week of data in our sample.

7

of the ABS and HN model on option prices computationally tedious, with little
additional information.
The risk-free rate of return for each particular option maturity is calculated by
quadratic interpolation of the term structure of US Treasury Bill interest rates. We
use the mid-point of the bid-ask quote as the option price. We also account for
dividends paid out over the options life by calculating their present value and
subtracting it from the current index level. To avoid later problems during the
calibration process, we also discard option contracts that meet the following
filtering criteria:
1) Options for which the bid-ask spread is smaller than the minimal tick size
(5 cents for options are worth less than 3$ and 10 cents for all other
options), as well as options with price quotes lower than $S8. This allows
us to avoid concerns of price discretization
2

2) Options with a time to maturity less than 10 days or more than 360 days, to
avoid liquidity-driven pricing biases
3) Options with an implied volatility superior to 70%
4) Put and call options that violate the no-arbitrage relationship. Let C(t) be
the call price of a call option with strike K and time to maturity I t , let
P(t) be the corresponding put price and let S
t
be the current index level,
net of dividends. Options that violate the following inequalities are
discarded:
Table 2 provides the detail of the data filtering process. For OTM options, about
37% of the data has been screened out, which leaves us with a sizeable sample of
164,675 options.

Table 2:
Results of the filtering process
Total OTM options 263,127
Number of discarded options Filtering criterion
49,933 Price (<$0.375)
161 Bid-ask spread <min. tick size

52,822
Maturity<10 days
Maturity>360 days
6551 Implied volatility>70%
421 Violation of the no-arbitrage rule
Total rejected options 98,556
Remaining OTM options 164,571

2
see Bakshi et al (1997) or Gruber et al (2010)


C(t) > max(u, S
t
Kc
-(1-t)
)
( 1 )
P(t) > max(u, Kc
-(1-t)
S
t
)

8

We now proceed to describe the filtered sample. To this end, we follow Barone-
Adesi, Engle and Mancini (2008), Bollen and Whaley (2004) and Bakshi et al
(1997) and segregate our option data into moneyness and time to expiration
categories. Regarding time to maturity, an option can be labelled short-term
( I < 6u days), medium-maturity ( 6u I 18u days) and long-maturity
(I > 18u days). We also define three moneyness categories based on the options
delta
3
. Call options at time t are classified as deep-out-of-the-money (DOTM) if
u.u2 < A
C
u.12S, as out-the-money (OTM) if u.12S < A
C
u.S7S and as near
the money if u.S7S < A
C
u.62S. Similarly, put options are said to be deep-out-
of-the money for u.12S < A
P
u.u2, out-of-the-money for u.S7S < A
P

u.12S and near-the-money for u.62S < A
P
u.S7S. Table 1 describes some
sub-sample properties for our 164,675 options contracts, divided into six
moneyness-maturity categories.
Table 3: Description of the option data
Maturity
Moneyness I < 6u 6u I 18u I > 18u
DOTM Mean Volume 1404,49 340,46 157,37
Mean option price 2,33 4,61 7,67
Mean o
BS
0,27 0,27 0,26
% of puts 0,67 0,66 0,63
Observations 22.861 18.678 14.667

OTM Mean Volume 1837,25 640,14 230,12
Mean option price 11,16 20,62 34,10
Mean o
BS
0,24 0,24 0,23
% of puts 0,57 0,61 0,61
Observations 19.595 21.630 21.218

NTM Mean Volume 2111,43 869,81 244,56
Mean option price 27,66 45,93 73,63
Mean o
BS
0,22 0,22 0,21
% of puts 0,06 0,11 0,10
Observations 8385 9568 8957
We provide summary statistics for the average bid-ask midpoint price, the Black-
Scholes implied volatility, the average trading volume, the proportion of put
options and the total number of observations. The average midpoint prices range
from $2.33 for DOTM options with short time to expiration to $73.63 for long-
maturity NTM options. NTM puts (all maturities together) are considerably less
represented in the total sample as the other categories: they only account for 1.6%
of our sample, compared with 25.3% for DOTM puts and 16.8% for NTM calls.
The average trading volume is highest for NTM short-term options and decreases
as time to expiration increases and moneyness decreases. The average option
midpoint price increases along with moneyness and maturity and is maximal for
long-term NTM options. Table 3 also shows distinctive patterns for the implied
volatility. Given a certain level of moneyness, the implied volatility decreases as
the options time to expiration increases. The volatility smile also manifests itself
across moneyness categories for a particular maturity category. The mean number

3
see for example Bollen and Whaley (2004)

9

of option contracts per Wednesday is 218.6, with a standard deviation of 118.70, a
minimum of 92 and a maximum of 647.
Index data
Figure 1 shows the evolution of the level of the S&P 500 index over the sample
period, the daily log-returns for Wednesdays only and the autocorrelation of
squared returns. The index level ranges from a minimum of $606.37 on January
17
th
, 1996 to a maximum of $1562.5 on October 10
th
, 2007, with an average of
$1132 a standard deviation of $227.41. It is important to note that our sample
period contains the bursting of both the dot-com, in early 2000, and the US credit
bubble, in late 2007. This is a noteworthy feature of our sample since we are a
priori interested in the dynamic behavior of the time-varying HN and ABS pricing
errors during these periods of financial turmoil.
Figure 1: S&P 500 index level (Wednesdays only), daily log-returns and autocorrelation of squared
returns





10

Log-returns oscillate around a mean close to zero (7.21e-4), with standard
deviation of 0.0254 on a daily base, and skewness and kurtosis of -0.59 and 7.043
respectively. One can discern distinctive patterns in volatility from the second
plot, with a period of low volatility between 2003 and 2007 and times of high
volatility during the two crises. Current squared log-returns are also slightly
correlated with their lagged values, as shown in the last plot, with values around
0.2 for the first five lags. GARCH models, such as the one that we will present in
the next section, are particularly suited to account for the excess kurtosis of the
returns distribution (7.043 compared to 1 VN = u.uS6 / under the i.i.d. hypothesis)
and the autocorrelation of squared returns.
Option pricing models
We now proceed to the description of the two option pricing models we rely on to
estimate the time series of the option pricing error on out-of-the money S&P500
index options over the period January 1996-June 2010.
Ad-hoc Black and Scholes model
The ad-hoc Black and Scholes option pricing formula (hereafter ABS), proposed
by Dumas, Fleming and Whaley (1998), refers to a Black-Scholes pricing model
for which the implied volatilities of the options are smoothed across a series of
explanatory variables. Let C(t) be the call price of a particular European call
option at time t. The Black-Scholes model yields the following expression for
C(t):
where S(t) is the spot price of the underlying asset at time t net of the discounted
value of expected dividends paid over the options life, K is the strike price of the
option, I is its maturity date, r is the risk-free interest rate, N(J) is the cumulative
unit normal density function with upper limit d and
The ABS approach extends the classical Black-Scholes model by taking into
account the well-documented volatility smile exhibited by the implied volatilities
of real options. This is exhibited in equation ( 3 ) and ( 4 ), in which o
t
is a
deterministic quadratic function of the following form:
The model in equation ( 5 ) captures variations of o
t
due to disparities in relative
moneyness and maturities among the set of options that are neglected when using
the original Black-Scholes approach, which assumes constant volatility o
t
= o
0
.
A minimum value for o
t
is imposed to avoid any negative volatilities values. We
choose to restrict our deterministic volatility function to quadratic terms, which, as


C(t) = S(t)N(J
1
) Kc
-(1-t))
N(J
2
) ,
( 2 )


J
1
=
In (S(t) K / )+(+0.5c
t
2
)1
c
t
V1
,
( 3 )


J
2
= J
1
o
t
VI ,
( 4 )


o
t
= max _u.u1, o
0
+o
1
S
K
+ o
2
_
S
K
]
2
+o
3
I + o
4
I
2
+o
5
I
S
K
_
( 5 )

11

pointed out in Dumas, Fleming and Whaley, are necessary to fit the parabolic
shape of the volatility smile. Berkowitz (2008) shows that in most cases, higher
order terms do not improve the cross sectional fit of the smile and only result in
overparameterization. Note that we also choose to smooth the implied volatilities
across relative moneyness (SK), as in Bollen and Whaley (2004), rather than
across strike prices, as in the original formula in Dumas, Fleming and Whaley
(henceforth DFW). As we discuss later when we present our results, the model
we present here performs considerably better than the original model specified in
DFW.
Heston and Nandi GARCH Model
Return dynamics
Heston and Nandi (2000) present a discrete-time GARCH model with Gaussian
innovations for the variance of a spot asset, from which they derive a closed-form
valuation formula for European options. In this research, we will focus exclusively
on the simplified first-order case (p = q = 1)
4
. In the Heston and Nandi model
(hereafter: HN), the log-spot price follows the following GARCH process over
discrete time steps of length A:



R
t
= ln _
S(t)
S(t 1)
_ = r +zb(t) +b(t)z(t)
( 6 )
where S(t) is the spot price of the underlying asset at discrete time step t net of
the discounted value of expected dividends paid over the options life, R
t
is the
one-period log return on the spot asset between t A and t, r is the continuously
compounded interest rate between the discrete time intervals t A and t, z(t) is a
standard Gaussian white noise series, z(t)~N(u,1) , b(t) is the conditional
variance of the log return between t A and t, and 0 = (, o
1
, [
1
, y
1
, z) are the
GARCH pricing parameters under the historical measure ".

The GARCH parameters 0 = (, o
1
, [
1
, y
1
, z) influence the nature of the
variance process, which itself shapes the distribution of log-returns. Different
values for 0 therefore lead to different payoff distributions. The parameter o
1

controls the kurtosis of the log-return distribution, and o
1
= u is equivalent to a
deterministic time-varying variance process. Note also that for o
1
= [
1
= u, the
variance becomes constant, which yields a valuation model equivalent to a Black
and Scholes model observed at discrete intervals. Parameter y
1
determines the
skewness of the distribution and captures the negative relationship between shocks
to returns and volatility, also called the leverage effect
5
. Finally z acts as a risk-
premium parameter. The conditional mean of the log asset return is given by:


4
see Heston and Nandi (2000), pp. 588-589.
5
see, for example, Christoffersen and Jacobs (2004) or Heston (1993)



b(t) = +[
1
b(t A) +o
1
[ z(t A) y
1
b(t A)
2
,
( 7 )

12


Where J
t-A
denotes the information set available at time step t A. The
conditional expectation for the log return, as expressed in ( 8 ), consists of a
riskless rate r and a risk premium zb(t). A noteworthy feature of the HN
GARCH model is that the conditional variance of spot returns between steps t and
t +A, b(t +A), is directly observable at time t, from the values of the current
GARCH parameters 0, the conditional variance b(t) between t A and t and the
current and lagged prices of the spot asset. Isolating the Gaussian innovation term
z(t) in ( 6 ) and substituting in ( 7 ) yields:
The model, specified under the historical measure ", is not fit for the direct
valuation of derivatives. Pricing real options requires us to derive the risk-neutral
distribution of the spot price. In this section, we simply provide the risk-neutral
version of equations ( 6 ) and ( 7 ), further detail on their risk-neutralization can be
found in the original article by Heston and Nandi (2010). Under the risk-neutral
measure Q, equations ( 6 ) and ( 7 ) become :



ln _
S(t)
S(t 1)
_ = r
b(t)
2
+b(t)z
-
(t)
( 10 )
The risk-neutral process is equivalent to equations ( 6 ) and ( 7 ), with parameter z
set to u.S, and y
1
replaced by y
1
-
= y
1
+z +u.S. Rewriting equation ( 9 ) for the
one-period conditional mean of the log asset return with the risk-neutral
parameters 0
-
yields:

The one-period conditional return from investing in the spot asset is therefore
equal to the risk-free rate. The conditional variance of the spot asset under the
risk-neutral measure is given by:
Note that the expressions for the conditional variance b(t +A) under the historical
and risk-neutral measures are equivalent. The proof is trivial: plugging y
1
-
= y
1
+
z +u.S into equation ( 13 ) yields the expression for b
"
(t +A) in equation ( 9 ).
Call option valuation formula
The value C(t, K, I, S
t
, b
t+1
, r, 0
-
) at time t of a European call option is given by:
p
t
= E
"
(R
t
|J
t-A
) = r +zb(t),
( 8 )


b(t +A) = +[
1
b(t) +o
1
(R(t) r zb(t)) y
1
b(t))
2
b(t)

( 9 )



b(t) =
-
+[
1
-
b(t A) +o
1
-
[ z
-
(t A) y
1
-
b(t A)
2

( 11 )

p
t
-
= E
Q
(R
t
|J
t-A
) = r
( 12 )



b
Q
(t +A) = +[
1
b(t) +o
1
(R(t) r +b(t) 2 / y
1
-
b(t))
2
b(t)

( 13 )


C = c
-(1-t)
E
Q
|max((S
1
) K, u)] = S
1
P
1
+Kc
-(1-t)
P
2

( 14 )

13

where K is the strike price of the option, I is its maturity date, and E
Q
denotes the
expectation under the risk-neutral measure. The left-hand side expression for the
call option value can be reformulated by means of the risk-neutral probabilities P
1

and P
2
, where P
1
is the delta of the call and P
2
= Pi (S
1
> K) is the probability
that the spot price at maturity S
1
exceeds the strike price K. The risk neutral
probabilities take the form:

Rc denotes the real part of a complex number, and
-
() is the conditional
generating function of the asset price for the risk neutral process. For the first-
order HN process described by equations ( 6 ) and ( 7 ), () takes the following
log-linear form:
Where coefficients A(t; I; ) and B(t; I; ) are calculated backward from the
terminal conditions A(I; I; ) = B(I; I; ) = u and the following recursive
equations:
The prices of put options are derived from the call price in ( 14 ), using the put-call
parity.
Reasons for choosing the ABS and HN models
The option pricing literature has produced a large number of models for the
valuation of European options such as those on the S&P 500 index. In this
research, we choose to compute the time series of the cross-sectional pricing error
for two particular models: the ABS and the HN model. This section briefly
motivates our choice. The ABS, as we described it above, is theoretically
inconsistent. Indeed, smoothing Black-Scholes implied volatilities across
moneyness and maturities and then plugging them back in equation ( 5 ) violates
the assumption of constant volatility underlying the original Black-Scholes pricing
formula. As some authors argue
6
, the ABS procedure may be viewed as nothing
more than a sophisticated interpolation tool that provides an implied volatility
surface. However, this pricing approach is widely used among option traders and
practitioners and is frequently used as a performance benchmark in the option

6
see Berkowitz (2010) or Davis (2001)


P
1
=
1
2
+
c
-r(T-t)
nS
T
] Rc j
K
-i
]
-
(q+1)
q
[ J

0

( 15 )


P
2
=
1
2
+
1
n
_ Rc _
K
-q

-
(i)
i
_ J

0

( 16 )

() = E|S
1
q
] = S
t
q
exp|A(t; I, ) +B
1
(t; I; )b(t +A),
( 17 )


A(t; I, ) = A(t +A; I, ) +r +B
1
(t +A; I; )

1
2
ln(1 2o
1
B
1
(t +A; I; ) )
( 18 )


B
1
(t; I, ) = (z +y
1
)
1
2
y
1
2
+[
1
B
1
(t +A; I; )
+
1 2 / (
1
)
2
1 2o
1
B
1
(t +A; I; )

( 19 )

14

pricing literature
7
. As these studies have shown, it consistently competes with
other models. Another advantage of the ABS model is that, due to its theoretical
inconsistency, it does not make any assumptions on the nature of the variance
process. The time-varying trend observed for its error series is therefore
independent of any theoretical constraints. This is not the case for the HN model,
which, for example, ignores jumps and relies on the assumption of a continuous
variance process. The HN error time series might therefore depend on time
varying jump likelihood.

We also choose to estimate the time series of the error for the HN GARCH
model. We justify this choice by the fact that GARCH models allow us to price
options without implying volatilities from the Black-Scholes formula, as valuation
is based on observables, such as the discrete observations of the underlying asset
price. The main advantage of the model developed by Heston and Nandi over
other GARCH models is that it has a closed-form solution and therefore does not
require the use of Monte Carlo simulations. Option prices, as equation ( 14 )
shows in the previous section, can be directly obtained from the history of asset
prices, option specifications and a finite number of risk neutral parameters
0
-
= (
-
, o
-
, [
-
, y
-
). We mainly consider the HN GARCH in our analysis to
assess the generalizability of our ABS results. We want to determine whether our
results for the ABS model can be replicated using a more theory-based model.
Similar results for two diametrically different models would suggest the existence
of the common pattern we are looking for.
Calibration
We now turn to a more in-depth description of the methodology used in the
calibration of the two models on the sample of option data.

ABS procedure
On each Wednesday of the sample, the implied volatility surface o
t
(S K / , I) of
equation ( 5 ) is calibrated on market data. We implemented a non-linear least
square (NLS) procedure
8
that minimizes an objective function, defined as the
dollar root mean squared error between model option values and observed option
prices ($RMSE). This cross-sectional fitting gives us 754 sets of optimized
parameters o
0
t
, o
1
t
, o
2
t
, o
3
t
, o
4
t
, o
5
t
, one for each Wednesday t, which define 754
implied volatility surfaces. These surfaces, when plugged in the Black-Scholes
pricing formulae, allow the closest match of model prices to option prices on the
market. More importantly, the NLS procedure also yields a time series of the
minimized dollar root mean squared error, which we will use as input for our
empirical analysis detailed in the next chapter.
Figure 2 shows the calibration of the ABS model using NLS on the cross-section
of out-of-the-money SPX options on June 16
th
, 2010, as well as the smoothed
volatility surface on that day. The first plot shows that the option prices yielded by
the ABS model closely match the market prices over the range of maturities on

7
see for instance Barone-Adesi, Engle and Mancini (2008), Heston and Nandi (2000) or Brandt
and Wu (2002)
8
The optimization procedure is implemented in Matlab, using the active-set algorithm and the
fminunc function

15

June 16
th
, 2010. The second plot shows the smoothed implied volatility surface on
that day. Note that it has the expected shape: implied volatilities decrease as
moneyness increases, with a surface getting flatter as the options time to maturity
increases. Trend reversal occurs for long-maturity DOTM put options (K/S<0.4,
T>250 days), as the bottom-left portion of the surface shows.

Figure 2: Calibration of the ABS model on the cross-section of OTM options on June 16th 2010 and
smoothed volatility surface


HN-GARCH model
A similar method is used to calibrate the HN GARCH model on the option data,
although the optimization process calls for more precaution in this case. A first
important remark is that the NLS procedure is now more computationally
cumbersome, due to the intrinsic nature of the HN GARCH pricing formula:
estimation of the risk-neutral-probabilities in equation ( 14 ) requires numerical
integration and the handing of complex numbers, coefficients A(t; I; ) and
B
1
(t; I; ) need to be computed recursively, etc. In and out, the overall greater
number of operations makes the pricing of one cross section of options much
slower with the HN model than with the ABS procedure.
Second, the objective function ($RMSE) for the HN-GARCH model contains
jump discontinuities and its optimization often requires a large number of function
evaluations, which translate into prohibitively long running times. The results
generated by the NLS procedure are also very sensitive to the starting values for
0
-
=
-
, o
-
, [
-
, y
-
, provided as input for the optimizer. We therefore incur the
risk of running into local minima of the loss function ($RMSE), rather than the
global minimum we are looking for. A promising solution to alleviate such
concerns is to use algorithms such as the accelerated random search (ARS)
proposed by Mller et al (2013). Mller et al acknowledge the caveats of local
optimizers such as the one used in this research (active-set algorithms) for non-
smooth objective functions, and show that ARS leads to significantly better results
for the Heston and Nandi GARCH model. However, using ARS for our data
would require considerable computational power (several multi-core computers
for parallel processing) we did not have at our disposal for this study. We
therefore implement a middle-ground solution: the objective function is evaluated

16

at several starting points 0
-
and the optimization starts with the set of initial
parameters that yield the smallest objective function value.
Let t be any given Wednesday of our sample, with t = 1 corresponding to
January 17
th
1996 and t = 7S4 being June 30
th
2010. At each step of the NLS
procedure, prices for the cross-section of options at time t are calculated from
equation ( 14 ), and therefore depend on the values of 0
-
=
-
, o
-
, [
-
, y
-
and
b(t +A). The conditional variance b(t +A) is obtained from expression ( 13 ),
which depends on the GARCH parameters being optimized, the log-return of the
spot asset since last Wednesday t A, and the conditional variance b(t) between
t A and t. We decided to proxy for the variance b(t) by using an adjustment on
the CBOE volatility index (VIX) at time t A. This index uses real-time SPX
options bid and ask quotes to provide a daily forecast for the expected volatility of
the S&P 500 Index over the next 30 days. In other words, the VIX uses present
time information to form expectations on the SPX volatility for the near future.
This makes the lagged level of the VIX index a particularly good candidate to
proxy for b(t), defined as the conditional variance between the last period t and
the current period t, based on the information set available at time t A. Figure 4
shows the calibrated prices for the first day of our sample, Jan. 17th, 1996, and
Figure 3 shows the weekly VIX index level over our sample period.
Figure 4: Calibration of the HN GARCH model on the cross-section of OTM SPX
options on Jan. 17th, 1996
Figure 3: Weekly VIX Index level (Jan. 1996 - June 2010

17

Empirical Results
In previous sections, we provided an overall description of the sample of option
and index data used in this research, as well as an overview of the theory we rely
on to estimate the time series of the option pricing error. We now proceed to
present our empirical results, which we divide in two parts. We start with a section
comparing the in-sample and out-of-sample pricing performance of our two
models, ABS and HN, over our sample period 1996-2010. In a second part, we
then turn to regression analysis in an attempt to explain some of the variation of
the in-sample pricing error over time for our sample of out-of-the-money options.
Based on the existing literature on option pricing and stock return predictability,
we test the explanatory power of a series of potential predictor variables, for both
the ABS and the HN model. Next, we generalize our results to the whole spectrum
of moneyness, and we show, relying on the ABS model only, that our regression
results are robust to the inclusion of ITM and DITM options. Finally, we rely on
the time series of out-of-sample RMSEs for the ABS model and study the ability
of our explanatory variables to forecast future OOS pricing error.
I. Option pricing performance of the models
In-sample model performance
In this section, we describe the in-sample option pricing performance of the ad-
hoc Black and Scholes procedure and the Heston and Nandi GARCH model.
Figure 5 shows the time series of the in-sample dollar root mean squared error
($RMSE) for our two models. On the next page, Table 4 provides the yearly
means and standard deviations of the coefficient estimates for the two models, as
well as yearly descriptive statistics for the $RMSE.
Figure 5:
Time series of the in-sample option pricing performance (January 17
th
, 1996- June 30
th
, 2010)

As a first important remark, we note that for both models, pricing performance
does not appear to behave randomly over the sample period. For both the ABS and
HN, the time series of the $RMSE exhibits a marked trend in Figure 5, with
considerably higher and more volatile in-sample pricing errors around the two
crises in 2000 and 2008. After the dot-com bubble, the $RMSE seems to revert to
its original pre-crisis level. A similar trend is observed in the aftermath of the
Table 4: Calibration of the HN GARCH and ABS pricing models
HN
o
-
1u
-
[
-
y
-
1u
2

-
1u
-
Ann. Vol.

RMSE
Year Mean Std. dev. Mean Std. dev. Mean Std. dev. Mean Std. dev. Mean Std. dev. Mean Std. dev.
1996 2,21 1,89 0,04 0,08 7,99 3,25 0,08 0,17 0,120 0,011

1,37 0,39
1997 4,28 3,11 0,14 0,18 5,14 1,62 0,37 0,82 0,161 0,022

2,20 0,49
1998
4,79 1,80 0,01 0,04 4,80 1,29 0,04 0,19

0,206 0,039

3,76 1,33
1999 4,25 1,95 0,01 0,03 5,34 1,89 0,01 0,05 0,221 0,023

5,21 1,35
2000
4,66 2,37 0,03 0,07 4,98 1,61 0,04 0,25

0,175 0,020

5,19 1,03
2001 6,31 3,62 0,05 0,11 4,26 1,48 0,32 0,94 0,175 0,011

3,49 1,06
2002
8,07 6,20 0,14 0,20 3,61 1,23 0,39 0,90

0,187 0,027

2,22 0,53
2003 9,86 5,66 0,19 0,20 3,19 1,38 0,77 1,47 0,178 0,026

1,52 0,37
2004
3,38 1,71 0,07 0,14 5,96 2,16 0,10 0,31

0,143 0,013

2,10 0,55
2005 1,92 0,84 0,03 0,12 7,58 1,97 0,06 0,18 0,116 0,007

2,33 0,58
2006
1,57 0,66 0,02 0,07 8,31 1,92 0,04 0,17

0,110 0,009

2,60 0,52
2007 2,21 2,26 0,02 0,06 8,40 3,34 0,02 0,07 0,138 0,033

3,44 0,80
2008
8,46 7,00 0,09 0,14 4,03 1,85 0,37 0,84

0,225 0,064

3,30 1,11
2009
19,09 12,26 0,13 0,20 2,47 1,21 0,91 2,03

0,258 0,045

2,00 0,54
2010
7,81 4,38 0,05 0,16 3,89 1,30 0,43 0,80

0,199 0,024

2,49 0,87

ABS
o
0


o
1


o
2


o
3


o
4


o
5


RMSE
Year Mean Std. dev. Mean Std. dev. Mean Std. dev. Mean Std. dev. Mean Std. dev. Mean Std. dev. Mean Std. dev
1996 -0,878 0,190 1,33 0,31 -0,33 0,13 0,32 0,053 0,01 0,012 -0,33 0,049

1,24 0,25
1997 -0,610 0,148 1,01 0,22 -0,24 0,07 0,25 0,073 0,00 0,012 -0,26 0,078

1,81 0,42
1998
-0,715 0,107 1,17 0,20 -0,27 0,07 0,29 0,039 -0,01 0,012 -0,26 0,040

2,34 0,51
1999 -0,689 0,103 1,16 0,15 -0,30 0,06 0,23 0,046 -0,02 0,012 -0,17 0,026

3,16 0,59
2000
-0,465 0,100 0,82 0,14 -0,18 0,04 0,14 0,060 0,01 0,014 -0,14 0,049

3,59 0,73
2001 -0,325 0,098 0,61 0,16 -0,09 0,07 0,13 0,077 0,01 0,018 -0,15 0,055

2,35 1,07
2002
-0,294 0,117 0,58 0,13 -0,08 0,05 0,15 0,063 0,01 0,018 -0,19 0,040

1,34 0,44
2003 -0,262 0,086 0,47 0,09 -0,04 0,03 0,20 0,051 0,00 0,015 -0,20 0,023

0,85 0,19
2004
-0,472 0,098 0,69 0,15 -0,11 0,06 0,24 0,038 -0,01 0,008 -0,21 0,031

1,08 0,71
2005 -0,673 0,137 0,97 0,22 -0,20 0,08 0,28 0,042 -0,01 0,008 -0,25 0,034

1,44 0,24
2006
-0,921 0,160 1,35 0,26 -0,34 0,10 0,35 0,047 0,00 0,012 -0,33 0,048

1,96 0,30
2007 -0,947 0,131 1,47 0,18 -0,39 0,07 0,31 0,046 0,00 0,015 -0,31 0,041

2,43 0,52
2008
-0,509 0,199 1,00 0,20 -0,24 0,08 0,17 0,106 0,02 0,042 -0,21 0,038

2,00 0,74
2009
-0,293 0,073 0,61 0,09 -0,08 0,03 0,23 0,045 -0,01 0,018 -0,21 0,022

1,10 0,19
2010
-0,424 0,065 0,68 0,14 -0,09 0,04 0,27 0,026 0,00 0,016 -0,24 0,027

1,24 0,25
stock market crash in 2008, with $RMSEs reverting to their levels of 1996 or 2003.
The mean yearly coefficient estimates in Table 4 also hint at a non-random time series
behavior. For example, the HN coefficients y
-
and o
-
both exhibit extrema around the
climaxes of the credit crisis in 2009. Furthermore, the annualized GARCH volatility
in the last column, as given by 2S2(
-
+ o
-
)(1 [
-
o
-
y
-
2
) also exhibits two peaks
in 2000 and 2009. Altogether, these results suggest that the two series of pricing
errors share a common trend, and that this trend might be explained or even
forecasted by variables from our option sample (for example: average option price or
average trading volume), but also by index characteristics or other market variables
(such as fluctuations in investor sentiment or short-term interest rates). This will be
the focus of our regression analyses in the later sections of this paper.
Figure 5 also seems to indicate that, over our sample period, the ABS procedure
consistently prices options more accurately than the HN GARCH model. This directly
contradicts the results presented in Heston and Nandi (2000) and Barone-Adesi, Engel
and Mancini (2008). In both these studies, the HN-GARCH model is shown to
compete closely with the ABS model or even outperform it in terms of in-sample
pricing performance. Using the ABS model as their benchmark, Barone-Adesi et al
(BEM) show that, on a yearly basis, the HN-GARCH model persistently outperforms
over the years 2002-2004. Heston and Nandi (HN) report the same result for the in-
sample performance of the two models over the period 1992-1994. Surprisingly, our
calibration results, as shown in Figure 5 hardly confirm those results and even suggest
the opposite: the $RMSEs for the ABS procedure over 1996-2010 are consistently
lower compared to the $RMSEs of the HN GARCH model. This divergence in
findings is easily explained by differences in the specification of the ABS procedure.
Both BEM and HN use the original equations from DFW (1998) for their ad-hoc
Black and Scholes benchmark, which we will henceforth notate as ABS
DFW
to
differentiate it from our ABS procedure. In DFW, the implied volatilities are
smoothed across maturities and strike prices K, rather than across maturities and
moneyness ratio SK, as we do in equation ( 5 ). Although this may seem like a
benign difference, there is empirical evidence that input variable transformation in
implied volatility functions has a significant impact on pricing performance (see
Andreou et al. (2013)). To test for differences in performance across ABS model
specifications, we calibrate the original ABS
DFW
procedure on our sample of option
data and compare its pricing performance against that of the HN GARCH model.
Figure 6 shows that our results actually corroborate the findings in HN and BEM: the
HN model consistently outperforms the ABS
DFW
benchmark for 2002-2004.
Figure 6: Comparison between the original DFW procedure and the HN GARCH model




20

Figure 6 shows that the error for the ABS
DFW
benchmark especially deteriorates
during periods of financial turbulence. The errors for this model around the years
2000 and 2008 are roughly three times as high as those of the HN model and four
times as high as those of the modified ABS model. In and out, Figure 5 and Figure 6
suggest that the modified ABS procedure we use in this study, as described in Bollen
and Whaley (2004), is the most efficient at capturing the volatility smile over our
sample period. Not only does it largely outperform the original ABS
DFW
, it also
exhibits an overall lower level of pricing error than the HN-GARCH model. We
provide several reasons to explain that last result.
1) First, this might be due to liquidity biases. As pointed out in Berkowitz
(2009), the ABS procedure is able to price options of all maturities and moneyness
categories with a consistently impressive empirical performance, even for options
that are thinly traded. Since roughly 50% of the option contracts in our sample have
a daily volume inferior to ten trades, the performance gap between the HN-GARCH
model and the ABS procedure might be partially explained by the fact that the HN-
GARCH model prices illiquid options with less accuracy.
2) A review of the GARCH option pricing literature provides a second potential
explanation: the HN GARCH model is relatively inaccurate for certain moneyness
or maturity categories. Hsieh et al (2005) claim that the HN model underperforms
for deep-out-the-money options and Ferreira et al (2005) find that its pricing
performance deteriorates for options close to expiration. In fact, in their original
article, Heston and Nandi already report that for their GARCH model, short-term
OTM options are the most difficult to valuate. Since short-maturity OTM and
DOTM options are both represented in non-negligible numbers among our option
sample, it makes sense to investigate the pricing performance across our range of
moneyness and maturities. We investigate this matter in the next section of this
paper.
3) Finally, flaws in our calibration algorithm might also explain part of the
pricing performance gap. Indeed, even if the weekly $RMSEs in our two time series
are the outcomes of a minimization algorithm, it is important to acknowledge the
potential presence of local minima in our results, for both the HN and ABS model.
This might be more relevant for the HN-GARCH model, for which the objective
function minimized during the calibration process is a highly non-linear function
with jump discontinuities and a high sensitivity to starting values. We therefore
suspect that running the NLS procedure with a genetic algorithm might produce time
series of the pricing error that are slightly different than those we present in this
research, with larger differences for the HN-GARCH than for the ABS model.


21

In-sample performance across maturity and moneyness categories
In the previous section, we introduced the idea of comparing pricing performance of
our two models for different style of options. We suspect that the relative
underperformance of the HN GARCH model observed in Figure 5 might result from
the inability of the GARCH model to capture some parts of the volatility smile. For
example, the results presented in Hsieh et al (2005) and Ferreira et al (2005) tend to
suggest that DOTM options with short time to maturity might be more severely
mispriced by the HN GARCH model. To better understand the time series behaviour
of our two models over our aggregate sample of OTM options, we investigate the
pricing performance across several moneyness and maturity categories. As in the
description of the option data, we segregate our sample into three maturity categories:
short maturity ( I < 6u days), medium maturity ( 6u I 18u days) and long
maturity (I > 18u days). Building on Bollen and Whaley (2004), we also define
three moneyness categories based on the options delta: deep-out-of-the money
(u.u2 < A
C
u.12S for calls and u.12S < A
P
u.u2 for puts), out-of-the-money
(u.12S < A
C
u.S7S, u.S7S < A
P
u.12S) and near-the money (u.S7S < A
C

u.62S, u.62S < A
P
u.S7S). Figure 7 illustrates the results of our classification.
Note that due to our initial filtering of option data, we do not consider ITM or DITM
options. To generalize our results to the full sample of option data, we repeated the
analysis including ITM and DITM options, using only the ABS model. These results,
along with their interpretation can be found in Appendix 1. When calibration is
performed on the full sample of SPX options, the HN model requires prohibitively
long computation times, and it was therefore left out.
Figure 7 shows that the difference in valuation performance is not uniform across
the spectrum of maturities and moneyness. In fact, the two pricing models valuate
some option categories with almost identical accuracy. For example, the HN model
appears to compete on an equal basis with ABS for medium-maturity options and
only slightly underperforms for options with long time to expiration. For some other
categories, the performance gap between the models widens considerably. This is
especially observable for short-term options, for which the pricing error of the HN
consistently fluctuates above the level of its ABS counterpart. The HN model perform
worst for short-maturity DOTM and OTM options, for which the $RMSEs are more
than twice as high as for the ABS model. Figure 7 therefore confirms our intuition:
while the ABS model accurately valuates options across maturities and moneyness,
the HN model systematically fails to adequately capture some parts of the volatility
surface and therefore underperforms. Figure 7 also allows us to reject our previous
hypothesis that the larger errors of the HN model are due to its poor performance with
thinly traded options. Indeed, a look back at Table 3 reveals that the options with the
lowest average trading volumes are the ones with medium and long maturities, which
are also those for which the HN GARCH performs closest to the ABS model. We
therefore conclude from our results that from the three explanations we give in the
previous section, the second one is the most likely to explain the performance gap.

Figure 7: Comparison of the pricing error across moneyness and maturity categories for the HN and ABS models
Out-of-sample model performance
We now turn to out-of-sample (OOS) valuation performance for both our models. On
each Wednesday in our sample, the in-sample parameter estimates provided by the
calibration are used to value SPX options one week later. Figure 8 shows the time
series of the OOS dollar pricing errors for our two models.

Figure 8: Out-of-sample pricing errors of the HN and ABS models

As for the in-sample pricing errors, the two OOS time series exhibit similar trends,
with increasing levels of pricing error around periods of financial turmoil and
regression to pre-crisis levels afterwards. The ABS procedure also slightly
outperforms over our aggregate sample period, as was the case in-sample and
valuation errors seem to remain in the same range, with no sudden explosion in the
OOS $RMSE values. This comforts us in the idea that both models are flexible
enough to achieve good valuation performance. On any given day of our sample, both
ABS and HN appear to fit the dynamics of index returns as well as the shape of the
implied volatility surface quite accurately. Although the ABS model still outperforms
in general over the period 1996-2010, the difference in out-of-sample pricing errors
between the HN and the ABS model tends to be smaller than those observed in
sample in Figure 5.
Appendix 3 shows the time series of the differences in $RMSE between the ABS and
HN model in- and out-of-sample. The HN tends to outperform ABS more often when
out-of-sample valuation is considered. This partially corroborates the results of
Heston and Nandi (2000) and Barone-Adesi, Engle and Mancini (2008), who find that
the performance of the ABS model considerably deteriorates out-of-sample because it
captures pricing mechanisms by overfitting the data. However, even if the pricing
performance of the ABS model indeed deteriorates out-of-sample relative to that of
the HN model, our results suggest that the effect is only of moderate magnitude. This
indicates that even if the ABS model slightly overfits the data, its estimates remain
stable out of sample. Overall, and despite the small differences in performance
reported in this section, the pricing errors of our two option pricing models seem to
share a common component, which is the focus of our next section.

24

II. Factors of option pricing performance
Foreword
We mentioned in the beginning of this chapter that there were two major parts to our
empirical analysis. In the previous section, we covered the first part by documenting
the in-sample and out-of-sample performance of our two option pricing models. We
now turn to the second part of our study, which directly derives from our previous
findings. In our earlier description of the in and out-of-sample pricing errors for the
two models, shown in Figure 5 and Figure 8, we observed that the $RMSE time series
of the HN and ABS models seemed to exhibit more than just random fluctuations.
This intuition is further confirmed when we consider the time series behaviour of the
error across option categories in Figure 7. In all these charts, valuation errors seem to
behave over time in a synchronous pattern for both the ABS and HN models. This is
all the more striking considering that these models are diametrically different in
nature, which reinforces our belief in a common cyclicality. The sharp increases
around the two crisis periods, and the relatively stable errors in between, make the
error time series in Figure 5 resemble the S&P500 index curve shown in Figure 1.
This leads us to believe that valuation errors might vary along with fluctuations of the
index level, or even other market variables such as interest rates. Motivated by this
intuition, we decide to shift our focus: instead of comparing the differences in
performance between models, we try to detect common patterns in the two time
series. Moreover, if such a common trend exists, we want to identify its underlying
factors. In other words, our primary goal is to find factors able to explain why our
alternative models both perform well during some periods and why their accuracy
deteriorates in other periods.
Stationarity and unit root testing
As said above, the first step of our approach is to statistically prove that the time
series of the pricing error for the ABS and HN model share a common trend. One way
to back that claim would be to derive the cross correlation function the two time series
of errors, and look for high values for the correlations between the various lags of the
two series. However, we first need to consider the issue of stationarity. Indeed, before
making any inferences on common trends among our two time series, statistical
theory requires that our two $RMSE series be stationary, or in other words mean-
reverting. This condition will also need to be fulfilled when we use time series
regressions later in this chapter, in order to avoid spurious regressions. The outcome
of the unit root tests (see Appendix 4) for our two pricing error series seem to indicate
that both the ABS (p

= 12, p = u.S1,

= 1.7) and the HN (p

= 1u,
p = u.14,

= 2.41) $RMSE time series have at least one unit root. In other
words, the error time series for ABS and HN are integrated processes of order , with
1. This means that at least one order of differencing is necessary to induce
stationary behaviour. We calculate the first-difference of the two non-stationary
$RMSE series, A
t
=
t

t-1
. Charts representing these differenced series over our
sample period can be found in Appendix 2. A second round of ADF tests on those
differenced series shows that neither have unit roots, and that one order of
differencing was sufficient to induce stationarity.

25

Common trends among ABS and HN pricing errors
In the last section, we derived two stationary pricing error series by using first-
differences. We now show that these two differenced series share a common trend, by
calculating their cross-correlation (XCF) function. Figure 9 shows the autocorrelation
function of the two differenced series, as well the XCF function over twenty lag
values. Figure 10 shows the same features for the original non-stationary series for
comparison purposes. The first two charts of each figure show that first-order
differencing removed the slow, decaying pattern for the autocorrelations in the
original series. For the first-differenced series, autocorrelations fluctuate around zero
across lag values. In each case, the autocorrelation for the first lag is the only one
significantly different than zero, with values around around -0.5. This is a sign that
stationarity for the two error series may have come at the price of slight
overdifferencing. We acknowledge that caveat and address it later in the section on
time series regressions.

Figure 9: Autocorrelations and XCF function of first-differenced $RMSE series for ABS and HN

Figure 10: Autocorrelations and XCF function of original $RMSE series for ABS and HN


Note that the first-differenced error series are moderately correlated for lag 0
(Pearsons r = 0.40, p<0.001), which indicates that both in levels and in first-
differences, the $RMSE for ABS and HN move together over time. Furthermore, both
an Engle-Granger and a Johansen test for cointegration on the two original non-
stationary series reveal that the pricing errors for our models are cointegrated. The
results for these tests are shown in Appendix 5. Altogether, these results provide
statistical evidence to back the intuition we formulated earlier when describing Figure
5: HN and ABS, albeit relying on diametrically different constitutive equations,

26

exhibit a common trend in their valuation performance. This encourages us to search
for factors that could explain this observed trend.
Error forecasting variables
In this section, we try to determine a set of variables likely to explain the common
pattern in pricing errors across alternative models. We distinguish two broad
categories among our set of potential underlying factors: options market variables and
other market variables. The first set relates to characteristics of our sample of SPX
options, such as option maturity or moneyness. The second regroups factors that are
specific to the spot market for the S&P500 index, but also comprises other broad
market variables that we expect to have some additional explanatory power. We now
give the rationale behind our choice of error forecasting variables.
Option market variables
We already mentioned repeatedly the important impact of certain option
characteristics on pricing performance when we were comparing the ABS and HN
models in the previous chapter. Factors such as moneyness, time to expiration or
trading volume have been shown to influence model error in the existing option
pricing literature (Hsieh et al. (2005), Ferreira et al. (2005), Heston and Nandi (2000),
Barone-Adesi et al. (2008)). Our empirical results also provided evidence to support
that claim, with Figure 7 showing considerably different levels of errors across
moneyness and maturity categories. We therefore suspect variables such as mean
moneyness (defined as K/S), mean trading volume and mean maturity to influence the
pricing error over time. To check for additional patterns, we add three complementary
variables: number of options under 1$, total number of options and number of
untraded options. By doing so, we want to observe if large numbers of options with
very low prices, or zero trading volume have an influence on the overall $RMSE. The
variable total number of options is added to account for the explosive growth in size
of the S&P500 equity option market over our sample period
9
. Furthermore, we also
include the average implied volatility, the put-call ratio and deviations of the put-call
parity as predictors. We define the latter as the daily put trading volume divided by
the total trading volume. The put-call ratio is often considered a proxy for investment
sentiment by both finance academics and practitioners, and studies have successfully
linked it to stock returns. For example, Pan and Poteshman (2006) show that their put-
call ratio measure has significant predictive power for the returns of individual stocks,
with high (low) ratios indicating short-term underperformance (outperformance).
Since both our RMSE time series exhibit higher levels of pricing error during times of
crises, which can be considered as low-sentiment periods, we expect the put-call ratio
to explain some of the variance in pricing errors. Finally, we add deviations from the
put-call parity as our last option market variable. The put-call parity relationship
imposes that put and and call options with the same strike price and maturity should
have the same Black-Scholes implied volatility. In practice, however, deviations do
exist, due to short-sales constraints, difficulties to borrow the underlying stock, or


9
For our sample of option data, the number of OTM options traded daily increased from 92 on January
17
th
, 1996 to 557 on June 30
th
, 2010. In terms of intraday volume, the increase is even more
spectacular: from 31,179 on January 17
th
, 1996 to 449,726 on June 30
th
, 2010.

27

information asymmetries. For example, Lamont and Thaler (2003) argue that short
sales restriction on the spot asset can prevent arbitrageurs from restoring the
equilibrium between stock and options prices, which often lead to puts that are more
expensive than the corresponding calls. The impact of deviations from the put-call
parity on both the HN and ABS pricing errors is immediate. For example, for the HN
model, deviations directly lead to the mispricing of put options, since the put prices
are derived from call prices using the put call parity. To derive our measure of
deviations from the put-call parity, we use a measure similar to that used by Cremers
and Weinbaum (2010). On each day of the sample, we build pairs of put and call
options with the same strike price and time to expiration. We then calculate the
difference in implied volatility between each of these pairs of put and call options and
use the average daily difference as our proxy. Note that put-call parity deviations can
only be observed when the whole sample of SPX options is considered. Indeed, a put
and a call option can only have identical strikes and expiration dates if (1) both these
options are ATM or if (2) one is OTM and the other is ITM. We will therefore solely
include this variable in the regressions for the full sample of SPX options, which we
only estimate for the ABS model due to prohibitively long calibration times for the
HN model.
Other variables
In rational, efficiently functioning and complete markets, returns on the SPX index
and SPX options would be perfectly correlated and options would be valuated with
perfect accuracy. In practice, of course, options are priced with a certain level of
error, as our non-zero pricing error series show in Figure 5. Academics have studied
feedback effects between the spot and options markets extensively
10
. This stream of
research has shown that spot and derivatives markets interact through lead-lag
relationships in returns and volatilities, price discovery and information spillovers,
leading us us to think that market variables influencing stock returns might also affect
option pricing performance. As a result, we consider including internal
11
spot market
variables, such as one-period SPX returns, but also other broad market variables in
our set of error forecasting variables. We justify our choice of variables by reviewing
the findings of the literature on stock returns predictability. Our first step is to include
variables proper to the underlying S&P 500 index. We select the following index-
related variables as predictors: the one- period return, the trading volume on the day
of the pricing, the average volume over the last trading week, the observed volatility
over the last 10 days, the VIX index level, the volatility of volatility, the S&P 500
SKEW index level, the price to book ratio, the price-earnings ratio and the index
dividend yield. Note that although the VIX index, the SKEW index and the volatility of
volatility are option-based, we arbitrarily include them as index-related variables.
Our choice to include the contemporaneous and past trading volume on the index
relies on the visibility hypothesis described in Gervais Kaniel and Mindelgrin (2001).
They argue that shocks to trading activity, or volume, carry information about the
direction of future stock price movements. They postulate that unusually high trading
activity for individual stock creates shocks in trader interest, which lead to the

10
See for instance Conover and Peterson (1999), Gwilym and Buckle (2001) or Pan and Poteshman
(2006)
11
By internal variables, we mean variables that are specifically used as input for the ABS and HN
pricing formulae.

28

existence of a high-volume return premium over short term holding periods. They
build three value-weighted porfolios of stocks: a high volume portfolio, a normal
volume portfolio and a low volume portfolio. They show that, for formation periods
of one day and one week, the high-volume portfolio earns abnormal risk-adjusted
returns for holding periods of up to a hundred days, without being rebalanced. In a
similar portfolio study, Huang and Heian (2010) use a sample including all firms
listed on the NYSE and AMEX and study the existence of the high-value return
premium over a sample period of fifty years. Their results also support the existence
of a high-volume premium for holding periods of one to four weeks. They show that
the premiums are mostly concentrated in the first two weeks after the formation
period, that they monotonically decrease for extended holding periods, and that they
even become negative for periods longer than eight weeks. Building on this empirical
research, we hypothesize that if shocks to the trading volume of the index potentially
impact stock returns, they might also influence the option pricing error. To account
for both immediate and gradual impact of volume on pricing performance, we include
a contemporaneous measure of trading volume, trading volume on the day of the
pricing as well as a lagged measure, average volume over the last trading week. Both
volumes are defined in number of contracts traded.
Next, we include two measures of volatility for the S&P 500 index. The impact of the
volatility of the spot asset on option valuation is more direct than what we just
described for the trading volume. Indeed, the valuation formulae for the HN and ABS
model both take some form of index volatility as an input. For the ABS model, the
volatility used in the Black-Scholes pricing formula is implied from option prices,
which obviously depend on expected stock market volatility. In the case of the HN
GARCH model, the call price formula relies on the conditional variance over the next
period, b(t +A), which measures the expected variance between the current and the
next period to impact the pricing error. As we can see, the pricing performance is
likely to be influenced by the expectations the market has for the index volatility in
the near future. We account for that fact by adding one forward-looking measure of
volatility, the well-accepted VIX index level to our set of error forecasting variables.
Inspired by an article by Baltussen, Van Bekkum and Van Der Grient (2013), we also
decide to add the volatility of volatility (vol-of-vol) as forecasting variable. We use
the authors original proxy for the vol-of-vol, defined as the standard deviation of the
implied volatilities of ATM put and call options over the last 20 trading days. In their
empirical study, Baltussen, Van Bekkum and Van Der Grient sort individual stocks
by vol-of-vol into value-weighted portfolio quintiles and show that stocks in the
lowest quintile outperform those in the highest quintile by roughly 0.85% in the first
month after portfolio formation. They also show that their results are robust to
controlling for an extensive list of other known drivers of stock returns, such as size,
book-to-market ratio, beta, momentum factor, stock turnover, put-minus-call implied
volatilities or leverage. In light of these findings, we suspect that, as a measure
capturing uncertainty of expected stock returns, vol-of-vol might explain some of the
variance in the two time series of option pricing errors. In addition to the VIX index
level, whose inclusion we discussed earlier, we add another widely used index
released by the Chicago Board Options Exchange, the SKEW index. The skew index
provides traders and portfolio managers with a measure of the perceived tail risk of
the distribution of the SPX log returns at a 30-day horizon. It acts as an indicator for
the expected skewness of the distribution of log returns: when the SKEW level is
around a value of 100, the distribution of log returns is expected to be almost normal.
When the SKEW level is at higher values, the expected skewness becomes more

29

negative and the probability of outlier negative returns increases. Accordingly, the
SKEW index complements our measures of volatility by accounting for the fact that
the distribution of log-returns is not normal. Next, we provide the rationale for adding
the log price to book ratio, the log cyclically adjusted price-earnings ratio (CAPE)
12

and the log index dividend yield as predictor variables of the pricing error.
Pioneering articles by Fama and French (1988a, 1988b) and Campbell and Shiller
(1989) or more recently, research by Campbell and Viceria (2005), show that
variables such as the dividend yield or the price earnings ratio stock have significant
predictive power for stock returns. Fama and French (1998a) examine the predictive
power of the dividend yield on stock returns for various holding periods. Their study
stresses the importance of the holding horizon in stock return predictability: while the
dividend yield only explains less than 5% of the return variance for holding periods of
a month, it explains up to 25% of the 3-5 year return variance. Campbell and Schiller
build on this research by incorporating stock prices and the dividend yield in a Vector
Autoregressive model (VAR), along with the price/earnings ratio. They show that the
P/E ratio is a powerful predictor of stock returns, especially as the holding period
increases. Campbell and Viceira (2005) extend the VAR framework presented in
Campbell and Schiller by including bond and T-bill returns in the VAR model. Their
set of return-forecasting variables includes the log dividend yield, the nominal interest
rate on the three-month Treasury bill and the yield spread between long and short
maturity government bonds. Their article makes an important contribution to the
literature by showing the term structure of the return variance and covariance for
stocks, bonds and T-bills. In the specific case of stocks, they conclude that as holding
horizon increases, predictability from the dividend yield induces mean reversion,
which make stocks less risky to hold over long horizons. For their two other return
forecasting variables, short-term interest rates and term spreads, Campbell and
Viceira (2005) find no conclusive evidence of stock return predictability. In similar
research, Ang and Bekaert (2007) document the opposite: they show that at short
horizons, short-term interest rates have significant predictive power for future excess
returns. Since results differ across studies for the short-term interest rates and the term
spread, we decide to include both variables as explanatory variables, because we
suspect they might influence the option pricing error. We define short-term interest
rates as the log nominal interest rate on the 90-days Treasury bill and the yield spread
as the log difference between the yield on the five-year Treasury note and the yield on
the 90-days T-bill.
Finally, we also account for the fact that variations in investor sentiment might affect
the price of S&P 500 index options and leave room for mispricing. Han (2007) studies
the impact of investor sentiment on the shape of the implied volatility surface and the
risk-neutral skewness of index returns for SPX options. His results show that bearish
sentiment on the market leads to a more negative risk-neutral skewness of index
returns and a steeper volatility smile. For bullish markets, implied volatility smiles
tend to be flatter. In a more recent study, Frijns, Lehnert and Zwinkels (2012) present
a stochastic volatility that differentiates between three groups of option traders:
traders that trade on long-term mean reversion, traders that trade on short-term
patterns and traders that form expectations about future volatility based on
fluctuations in investor sentiment. The authors find that when the third group of

12
The CAPE or PE10 (Schiller) is based on average inflation-adjusted earnings from the previous 10
years


30

sentimental traders is accounted for, in- and out-of-sample pricing errors are
significantly reduced. Their results are in line with those of Han, and show that
sentiment is a non-negligible determinant of the shape of the volatility smile and
option prices. In this research, we include four commonly used proxies for investor
sentiment: the Baker and Wurgler sentiment index, mutual fund flows, the American
Association of Individual Investors (AAII) sentiment survey, and the Investors
Intelligence (II) Bearish Sentiment Index. The sentiment measure of Baker and
Wurgler (2006) is based on six proxies of investor sentiment: market turnover,
number of IPOs, first day return on IPOs, new equity issuances, and difference in
book-to-market ratios between dividend payers and non-dividend payers. In our
analysis, we use the modified version of the index, for which each proxy has been
orthogonalized with respect to the NBER recession indicator, consumption growth
and industrial production. This allows the index to capture pure sentiment
variations, rather than business cycle fluctuations. We obtain the historical values of
the index from the authors website. Our second proxy, mutual fund flows, has also
been shown to be a good measure of investor sentiment (see for example Ben-Refael
et al (2010) and Chiu and Omesh (2013)). We use the net monthly cash flows for
domestic US equity funds from the Investment Company Institute (ICI) as our
measure of sentiment. Finally, we include the AAII survey and the II report to
account for differences in sentiment between institutional and individual investors.
The AAII sentiment survey polls a random sample of individual investors every week
and requires the respondents to formulate expectations on how they think the market
will evolve for the next six months. Based on the responses, the AAII then calculates
the proportion of bullish, bearish and neutral investors. Following Brown and Cliff
(2004), we use the spread between the fraction of bullish and bearish investors as a
measure of investment sentiment. The II report gathers over a hundred independent
market newsletters every week and categorizes their content as bullish, bearish or
neutral. A bull-bear spread is then calculated, in a similar manner to that of the AAII.
At first, it may seem redundant to use four different proxies for investment sentiment.
We justify our choice by the fact that the contemporaneous values of these four
measures are relatively moderately correlated over our sample period, as the table in
Appendix 6 shows. Since our proxies for sentiment hardly move together over time,
we fear that using merely one of them might keep us from observing the real effect of
investor sentiment on the pricing error.

The inclusion of the ten option market variables and the fifteen other variables into
our set of error predictors leaves us with a total of twenty-five dependent variables for
our time series regressions. We show the time series of these predictors in Appendix
8. As it is often the case when working with financial time series, we face the problem
that our variables are not all sampled at the same frequency. For example, values for
the Baker and Wurgler sentiment index or those for the CAPE are only released
monthly by their respective authors. In this case, we use spline interpolation to
transform financial time series with monthly frequency to weekly data. A second
issue is that some of our pricing error predictors are non-stationary. To meet the
assumptions required by OLS regressions on time series, we need to induce
stationarity, either by differencing, or by detrending our raw predictor variables. The
procedure for unit-root testing is identical to the one we described in our previous
section on stationarity: advanced Dickey-Fuller tests are carried out on each predictor,
using the appropriate model (AR, ARD or TS) and the adequate lag length provided
by our information criterion. Trend-stationary variables are detrended and all

31

variables that fail to reject the ADF null hypothesis of non-stationarity are first-
differenced. Appendix 7 provides the results of the ADF tests for each predictor, as
well as an overview of the transformations used to induce stationarity. The next
section presents the results of our in-sample timeseries regression.
In-sample time series regression for the ABS model
The previous section provided the rationale behind our choice of variables to include
in our time series regressions. We also gave an overview of our unit-root testing and
data transformation process. We now proceed to the central piece of our research: the
time series regressions of the option pricing errors on our twenty-five explanatory
variables. Regression results are presented for the ad hoc Black and Scholes model,
for our filtered sample of out-of-the-money S&P 500 index options. We also provide
the regression estimates for the Heston and Nandi GARCH model as confirmatory
evidence in the next section. We first focus on in-sample regressions, and then turn to
out-of-sample prediction.
Table 5 shows the results of the multiple regressions of the pricing error on our set of
predictors for the ABS model. In all four regression model specifications, the
dependent variable is the first-difference of the $RMSE, and the values of the
predictors are contemporaneous to those of the dependent variable. We do not report
regression results for the level of the error, since the level series is non-stationary, and
its use in time series regressions would lead to spurious results. Note that we use four
models in our regression table. Model 1 refers to a first-order autoregressive process,
where the only predictor is the first lag of the dependent variable, Model 2 adds
option sample characteristics to the set of predictors, and Model 3 includes all other
predictors in the regression. Model 4 is a modified version of Model 3, for which all
predictors have been first-differenced. Also note that the volatility of volatility has
been omitted in Model 3, and that VIX index level is absent from Model 4. We
exclude these variables because of their high correlations with other predictors. In
levels, contemporaneous values of VIX and vol-of-vol are strongly correlated
(Pearsons r= 0.80, p<0.001). In first-differences, VIX and the average implied
volatility are strongly correlated (Pearsons r= 0.87, p<0.001). To alleviate
multicollinearity concerns, we therefore arbitrarily eliminate one of the variables in
each correlated pair of predictors
13
.

Model 1
A first look at the four columns of Table 5 confirms our previous intuition: in every
specification, some of our predictor variables are able to explain some fraction of the
variance in pricing error for the ABS model. As Model 1 shows, the mere lagged
values of the error already explain roughly 17 percent of the variance in pricing
performance. The coefficient estimate on the lagged $RMSE is negative and highly
significant, which indicates that a decrease in pricing error in the previous period is
likely to be associated with an increase in the current period. Note that the coefficient
estimate (-0.412) is simply the value for the first lag of the ABS error autocorrelation
function shown in Figure 9.

13
Our results are robust to replacing the VIX level by the vol-of vol in Model 3, and using the VIX
rather than the average implied volatility in Model 4.

32

Table 5: In sample regressions for ABS pricing errors (filtered sample of OTM options)
Model 1 Model 2 Model 3 Model 4

Lagged error -.412**
(0,033)
-0,413***
(0,033)
-0,412***
(0,033)
-0,423***
(0,032)
Mean option price 0,042***
(0,011)
0,043***
(0,011)
0,014
(0,013)
Mean moneyness -0,191
(0,394)
0,075
(0,611)
-1,224
(1,085)
Mean maturity 0,002
(0,001)
0,001
(0,001)
0,007***
(0,002)
Total number of options 3,904***
(1,133)
3,777***
(1,151)
0,004***
(0,001)
Number of untraded options -1,083
(1,258)
-1,406
(1,279)
-0,002
(0,001)
Number of options under 1$ -2,554
(1,771)
-1,893
(1,849)
-0,001
(0,002)
Put-call ratio 0,025
(0,180)
-0,018
(0,185)
0,079
(0,134)
Mean volume per contract 0,009
(0,058)
0,018
(0,058)
0,000008
(0,00006)
Mean implied volatility -0,282
(1,467)
2,137
(1,869)
3,680
(1,870)
VIX level 0,018
(0,373)
-
CAPE 0,525
(2,180)
0,705
(2,004)
Log T-bill interest rate 51,600***
(17,952)
62,951***
(16,79)
Log yield spread 40,658***
(14,477)
42,782***
(13,776)
Log dividend yield -0,050
(3,899)
-122,916***
(18,78)
Bull-Bear spread institutions 0,101
(0,205)
0,0003
(0,004)
Bull-Bear spread individuals -0,081
(0,132)
0,003**
(0,001)
Baker and Wurgler index 0,010
(0,494)
0,072
(0,457)
Skew level -0,001
(0,004)
-0,004
(0,006)
SPX volume -0,020
(0,019)
-0,00002
(0,00002)
SPX volume over past week -0,080**
(0,0393)
-0,00008**
(0,00004)
One-period log returns 0,014
(0,0105)
0,772
(0,669)
Price to book ratio -0,406*
(0,225)
-0,446**
(0,213)
Mutual fund flow -0,003
(0,014)
-0,00005
(0,00006)
Volatility of volatility - 0,015

Constant 0.001
(0,018)
-0,081
(0,443)
-0,238
(0,628)
0,00034
(0,031)

Num. Obs. 752 752 752 752
AJ. R
2
.1684 .1999 .2037 .2716

Reports the unstandardized coefficient, standard errors (in parentheses) and adjusted R
2
for the multiple
regressions of the in sample $RMSE on contemporaneous values of the predictor variables for the ad hoc Black
and Scholes procedure. Model 1 refers to an AR(1) model for the $RMSE. Model 2 and Model 3 respectively add
option market factors and equity market factors to the set of predictor variables. Regression model 4 is equivalent
to Model 3, with all predictor variables first-differenced. . ***, ** and * denote significance at the 1%, 5% and
10% level respectively.

33

In order to explain a higher fraction of the variance, we could also consider higher
order autoregressive models. To illustrate that claim, Appendix 9 shows the partial
autocorrelation function for the first-differenced pricing error of the ABS model. The
chart suggests that adding the second or third lag of the dependent variable as
predictors in Model 1 might increase the fraction of variance explained by a
significant amount. This also raises concerns that the inclusion of additional lags
might weaken the significance of our results for Model 2, 3 and 4 of Table 5, or even
eliminate the significance altogether. In untabulated results
14
, we show that our
regression results are unaffected by the inclusion of additional lags. For the sake of
conciseness, we only report our results for the first lag of the pricing error.

Model 2
As the second column of Table 5 shows, adding option market-related variables to the
set of predictors increases the adjusted fraction of explained variance to 20 percent.
The coefficient on the lagged difference in pricing error remains highly significant
and negative. Additionally, the coefficient estimates for Model 2 show that two more
predictors have a significant influence on the pricing error: the mean option price and
the first-difference of the total number of index options available for trade. The effect
of the mean option price on our measure of dollar pricing error is best understood by
considering our previous results. A look back at Table 3 shows that a high mean
option price on a given Wednesday is probably associated with a tilt toward long-
maturity or near-the-money options, which are the most expensive on average. Figure
7 also reveals that the level of pricing error for the ABS model increases as (1)
relative moneyness approaches unity and as (3) time to maturity increases. Combining
these two results, we provide the following explanation for the positive effect of the
first predictor: a high average price is associated with a tilt of the cross-section of
options toward more expensive options (long-maturity NTM options), which also are
those that are priced with the lowest accuracy by the ABS model. Ultimately, this
results in higher dollar pricing errors.
The effect of the second significant predictor, the total number of options, is
straightforward. To price options, the ABS model relies on the smoothing of the
volatility surface implied by option prices. An increase in the number of options
results in a more complex implied volatility surface that needs to be fitted with a fixed
number of six parameters, or degrees of freedom by the ABS procedure. This
translates into higher interpolation errors during the smoothing process, and
ultimately in higher valuation errors when the smoothed implied volatility surface is
plugged into the Black-Scholes valuation formulae. Note that, as our dependent
variable and unlike the mean option price, the total number of options is first-
differenced in the regression model, which means that an increase from the previous
week in the number of options is associated with in an increase in valuation errors.

Model 3
The inclusion of the rest of the predictors in Model 3 increases the adjusted R
2
by an
additional 0.4 percent, and the effects observed in Model 1 and 2 remain significant.
In addition to the lagged pricing errors, the total number of options and the mean

14
These results are available from the author upon request

34

average option price, four additional predictors (all first-differenced in the regression
model) appear to have a significant effect on the current pricing error.
First, Model 3 shows that both an increase in short-term interest rates and a
steepening of the yield curve for government bonds result in an increase in valuation
errors relative to the previous week. The effect for both interest rates and the yield
spread is highly significant at the 1% level. For the effect of the yield spread and
short-term interest rates on valuation error, we provide two explanations. First, there
might be a mechanical effect due to the way we model interest rates in our ABS
model. Consider the Black and Scholes valuation formula in equation ( 2 ). To
calculate the option price, the expected payoff of the option is discounted at the zero-
coupon rate r corresponding to the options maturity. In our ABS model, we calculate
this rate by interpolating the zero curve on the day of the pricing with quadratic
polynomials. Figure 11 shows the real zero curves for June 9
th
, 1999 and January 17
th
,
1996, along with their interpolation polynomial. The curves are representative for the
two typical shapes observed for the zero curve over our sample period: normal and
inverted. In the first case, an increase in the yield spread results in a more pronounced
curvature for the yield curve, which leads to a poorer fit of our interpolation
polynomial, which is limited to quadratic terms. Over our range of option maturities
(10-360 days), interest rates for short maturities (<60 days) are therefore
overestimated and those for long maturities (>180 days) are underestimated, as the
first chart of Figure 11 shows.

Figure 11: Zero curve interpolation, yield spread and option pricing error


This translates into the use of inadequate discount rates in the Black Scholes pricing
formula and ultimately in higher valuation errors. In the second chart, the yield spread
is negative, and an increase in its value has the opposite effect, since it results in a
flatter yield curve, a better interpolation fit and lower valuation errors. We therefore
believe that part of the effect of the yield spread on the pricing error is mechanical,
and that its sign depends on the shape of the zero curve. Since the yield curve has a
normal, concave shape more than 75% of the time over our sample period, the effect
of the yield spread on pricing error should ultimately be positive, as our regression
results show in Table 5. Interpolation errors might also partly explain the significant
positive effect of the short-term interest rates on valuation error. For some days of our

35

sample, the zero curve exhibits a hump for short-maturity interest rates, which also
results in a poorer fit of our quadratic interpolant, and ultimately in higher option
pricing errors. A second explanation for the positive coefficients on the yield spread
and the short-term interest rate is that high interest rates usually go along with periods
of economic uncertainty. In these crisis periods, there is an abundant demand for
protective puts from traders and portfolio managers who use these derivatives as
insurance against the eventuality of a crash. This unusual demand drives the prices of
short and medium term OTM and DOTM put options way above those of equivalent
call options, thereby distorting the shape of the implied volatility surface. Since this
distorted surface is used as an input for the Black and Scholes pricing formula, it
ultimately results in increased mispricing, which explains our results. We illustrate
this phenomenon later in this section using Figure 13.
Coming back to Table 5, Model 3 also shows that a downward movement for the
average trading volume of the S&P 500 index during the previous week is associated
with simultaneous increases in valuation errors. We provide the following hypothesis
to explain how the trading activity on spot markets influences valuation error. One
channel through which spot liquidity interacts with option markets is option market
makers, who often use the underlying asset to hedge their put and call option
positions. For example, Cho and Engle (1999) argue that the liquidity and bid-ask
spread in the options market is determined by the liquidity in the spot market, rather
by the activities in the derivative market itself. This means that low trading activity on
the spot market could lead to higher bid ask-spreads on the options market. In turn,
these higher bid-ask spreads might influence the shape of the implied volatility
function and therefore option prices (see Chou et al (2012)). We therefore argue that
the negative coefficient observed in Table 5 is attributable to higher liquidity costs on
option markets. Finally, a negative effect on the $RMSE is also found for the first-
difference of the price to book ratio, but this effect is only marginally significant.

Model 4
Finally, Model 4 shows the results of a full regression model for which all twenty-
four predictors have been first-differenced. This allows us to check for additional
effects that may not have been captured in Model 3, for which some of the variables
are expressed in levels and other in first-differences, as we explained when we
considered stationarity issues in the previous section. The adjusted R
2
for this last
specification is the highest among the four models, with a value of 27%. We note that
in addition to the 17% explained by the autoregressive nature of the $RMSE in Model
1, we are able to explain an additional 11% of the variance from option sample
properties, S&P 500 index characteristics and general market conditions. Regarding
regression coefficient estimates, those of the total number of options, the short-term
interest rate, the yield spread, the price to book ratio and the past week average
volume all remain significant and of the same sign. In addition, whereas the first-
difference of the mean option price does not appear to have any significant influence
on the pricing error, the coefficient estimate of the log dividend yield becomes highly
significant and negative after differencing. A similar effect is found for the mean
option maturity, whose first-difference has a positive highly significant impact on the
ABS pricing error. Finally, the coefficient on the AAII bull-bear spread, one of our
sentiment proxies, becomes positive and significant.

36

The influence of the mean option maturity on valuation error is rather straightforward
to explain, as options with longer time to expiration are harder to price than their
short-maturity counterpart. We discussed this already when we interpreted the
influence of the mean option price, and refer to Figure 7 for a classification of the
valuation error by maturity categories.
Regarding the highly significant negative coefficient on the dividend yield, a unique
cause is difficult to pinpoint but we provide the following insights. The direct
influence of the dividend yield itself on option prices is obvious. In the first term of
the Black and Scholes valuation formula, the spot price is discounted for expected
dividends. All other things left unchanged, an increase in the dividend yield reduces
the value of the first term in equation ( 2 ), and leads to lower option prices. The
magnitude of this effect is asymmetrical across maturities: it is stronger for long-
maturity options, for which dividends are discounted over longer periods, and almost
negligible for options close to expiration. What causes fluctuations in the dividend
yield is less clear: it can either arise from a change in the index level, or from a cut in
the overall amount of dividends paid out on the index constituents. As the mirrored
curves in Figure 12 show, variations of the dividend yield are usually due to price
fluctuations: when price increases, the dividend yield decreases. Dividend payouts
themselves change rather smoothly over time, since sudden cuts send negative signals
about future performance, and usually lead market participants to punish companies
by moving their investment elsewhere. However, a closer look at the two crises in
2000 and 2008 shows that during these periods, variation in the dividend yield might
arise from sudden changes in the amount of paid dividends itself. In 2008 for
example, many large companies of the S&P 500 suspended or cut dividends, mostly
financial institutions such as Bank of America Corp., but also other firms such as
General Motors, resulting in $33 billion of unpaid dividends to stockholders
15
. In
2001, the fraction of S&P500 constituents paying dividends was down 15% relative to
that in 1996 (source: S&P indicated rate change spreadsheet). In light of this
information, we believe the negative coefficient on the dividend yield in Table 5
arises from specificities of our sample period, which contains two major recession
periods in fifteen years of data. We argue that the link between the dividend yield and
the valuation error might be coincidental, since period with sharp decreases in the
former correspond to periods of increases in the latter. If this is the case, we expect
the coefficient to become insignificant over longer sample periods. We also suggest a
second possibility, which is related to the assumptions of our pricing model. In the
ABS pricing model, the expected dividend yield over the options remaining life is
approximated by a constant, which is the current S&P 500 index dividend yield on the
day of the pricing. Using this constant yield, the ABS model calculates the present
value of all future dividends paid on the S&P500 index until the options expiration.
In reality, as we showed in Figure 12, the dividend yield is very unlikely to remain at
its present level over the options remaining life (especially for long-maturity options)
if it experienced a recent series of consecutive large drops over the past few weeks.
While the ABS model does not incorporate that information, we hypothesize that
option market participants do. We suggest that they are influenced by recent
consecutive decreases in the dividend yield (for example during crisis periods), which
leads them to use a different dividend yield, adjusted on their pessimistic expectations
for the future evolution of the index dividend yield. We suggest that this effect is

15
source: The Wall Street Journal


37

asymmetric: market participants are less affected by recent increases than decreases in
the dividend yield. This could would lead to a discrepancy between model and market
prices and provide a second possible explanation for why the level of ABS pricing
error increases when the dividend yield decreases. Determining which of the first or
the second theory is the most likely to explain our results in behind the scope of this
study. However, in both cases, we are fairly convinced that the negative coefficient on
the dividend yield is linked to the two crisis periods.
As conclusive remark before discussing the regressions results for the Heston and
Nandi GARCH model, we stress out that one must remain critical when interpreting
our regression results. Although great attention has been devoted to any possible
collinearity or non-stationarity issues among our set of variables, we insist on the fact
that many of our variables are weakly or moderately correlated. First differencing
alleviates most of these concerns, but the issue of the representativeness of our sample
remains. It may be that some of the relationships we discussed above are specific to
our sample period.

Figure 12: Dividend yield and pricing error



38

In sample regressions for the HN GARCH model
We present the results in this section as confirmatory evidence for the relationships
we just described for the ABS model. Table 6 shows the results of the same four
regression models used in the previous section for the HN model.

Model 1
The results for Model 1 globally corroborate what we found earlier: the first lag of the
$RMSE explains a non-negligible fraction of the variance in pricing error and the
coefficient estimate for this predictors is negative and highly significant at the 1%
level. Note that for this first regression model, the coefficient estimates and the
adjusted R
2
are almost identical to those for the ABS model in Table 5.

Model 2
Extending our set of predictors to option characteristics yields a significant 11%
increase in the percentage of variance explained. As for the ABS model, the total
number of options and the mean option price are both positive and highly significant.
A noteworthy difference between the two option pricing models is the lesser
explanatory power of the lagged $RMSE in Model 2, and the much higher adjusted
R
2
of Model 2 (0.295 vs 0.20 for the ABS model). This is easily explained by the
additional effect of the number of untraded options, the put-call ratio and the mean
implied volatility. The coefficient estimates on the number of untraded options and
the put-call ratio are both negative, whereas the coefficient on the mean implied
volatility is positive.

Model 3
The inclusion of all other predictors in Model 3 produces the largest change in terms
of variance explained and coefficient estimates. The adjusted R
2
jumps to 0.46 and
the coefficients of Model 2 experience radical changes when the additional variables
of Model 3 are added to the regression model. For example, the explanatory power of
the put-call ratio simply disappears, the coefficient on the mean implied volatility
changes sign and the coefficient on the mean moneyness becomes negative and highly
significant. This is mainly explained by the inclusion in Model 3 of one-period log
returns. For the HN GARCH the explanatory power of this specific variable is
considerable: in Model 3, log-returns are the second major explanatory variable for
the pricing error (t = 14.41, p = 1.42 1u
-41
), after the first lag of the error
(t = 14.47, p = 6.8 1u
-42
). The log-returns on the S&P 500 index alone explain
more than 15% of the variance in the dependent variable. We argue that this
divergence from our previous results for the ABS model is due to the fact that for the
HN model, option prices and therefore valuation errors are directly dependent on the
recent history of index returns. As for the ABS model, the coefficient on the total
number of options and the mean option price remain positive and highly significant.

In addition, the short-term interest rates and the yield spread both have the same sign
and level of significance as for the ABS model, which confirms their influence on
pricing performance. Table 6 also reveals that decreases in mean moneyness lead to
an increase in valuation error. We provide the following explanation for this effect.
We defined mean moneyness as the ratio K/S, with high values of this ratio (way
above 1) corresponding to DOTM calls and low values (way under 1) to DOTM puts
options. Since our filtered sample is restricted to OTM options, a decrease in mean

39

moneyness translates into a more pronounced tilt toward put options. The coefficient
for the mean moneyness therefore indicates that when the set of options becomes
gradually tilted toward put options, the valuation error increases. We believe that this
link between moneyness and error might be attributable to specific features of our
data during the two crisis periods, with period of very high valuation errors being
periods with high demand for DOTM crash-protective puts. To illustrate that claim
we show the $RMSE surface on two different days of our sample. In the first chart,
the pricing error is highest for long-maturity DOTM options, and decreases as
moneyness increases and the expiration date approaches. The shape of the first
surface is typical for a vast majority of the days in our sample. The second surface,
however, shows a distortion, which is almost entirely attributable to the mispricing of
DOTM and OTM put options with shorter time to maturity. This chart, shown in the
midst of the 2008 financial crisis, illustrates the effects of an abnormal demand in
DOTM and OTM puts on valuation error. We argue that this phenomenon might
explain to some extent the negative coefficient on mean moneyness in Table 6.


Figure 13: Illustration of the distortions created by abnormal demand for "crash-protective" puts


From Table 6, we also observe that both increases in mean implied volatility and the
number of untraded options result in lower valuation errors.

Model 4
Finally, Model 4 shows the results of a regression model for which all independent
variables have been first-differenced. Our main conclusions from Model 3 remain,
with the exception of the coefficient on the mean moneyness, which becomes
unsignificant for Model 4. Interestingly, a negative influence of the price to book ratio
(as for the ABS model) and a negative influence of the institutional bull-bear spread
are also found to be significant. From the results of Model 4, it appears that an
upward movement in institutional sentiment leads to an improvement in pricing
performance for the HN GARCH model. For the ABS, we found a relationship of the
opposite sign for the individual bull-bear spread, which renders interpretation difficult
for these measures of investor sentiment. Nevertheless, we argue that the major
decreases of institutional sentiment coincide with recession periods for our sample
period. This adds to our previous evidence in favor of a positive relationship between
financial market trouble and deterioration of pricing performance. This concludes our
discussion of the in-sample regression results. In the previous two sections, we
showed that as much as 11% (30%) of the variance in valuation error for the ABS

40


Table 6: In sample regressions for HN pricing error (filtered sample of OTM options)
Model 1 Model 2 Model 3 Model 4

Lagged error -.431**
(0,033)
-0,391***
(0,031)
-0,394***
(0,027)
-0,274***
(0,028)
Mean option price 0,130***
(0,017)
0,131***
(0,016)
0,132***
(0,019)
Mean moneyness -0,532
(0,617)
-2,407***
(0,837)
-1,540
(1,53)
Mean maturity 0,003
(0,002)
0,001
(0,002)
0,00011
(0,003)
Total number of options 9,381***
(1,779)
10,315***
(1,581)
0,009***
(0,002)
Number of untraded options -4,225**
(1,968)
-4,582***
(1,751)
-0,005***
(0,002)
Number of options under 1$ 1,118
(2,771)
0,155
(2,533)
0,003
(0,003)
Put-call ratio -0,691**
(0,281)
-0,019
(0,253)
-0,252
(0,19)
Mean volume per contract 0,098
(0,091)
0,055
(0,079)
0,00010
(0,00008)
Mean implied volatility 4,996**
(2,295)
-15,897***
(2,558)
-12,731***
(2,61)
VIX level 0,577
(0,511)
-
CAPE 4,692
(2,99)
-1,36
(2,790)
Log T-bill interest rate 84,72***
(24,585)
93,406***
(23,37)
Log yield spread 39,303***
(19,84)
52,74***
(19,193)
Log dividend yield -3,11
(5,341)
-183,682***
(26,124)
Bull-Bear spread institutions 0,188
(0,280)
-0,017***
(0,005)
Bull-Bear spread individuals 0,251
(0,181)
-0,002
(0,00191)
Baker and Wurgler index -0,396
(0,676)
-0,42835
(0,636)
Skew level -0,00019
(0,0055)
-0,01040
(0,00801)
SPX volume -0,01614
(0,0267)
-0,00002
(0,00003)
SPX volume over past week -0,00001
(0,054)
-0,00001
(0,00005)
One-period log returns -0,206***
(0,014)
-12,434***
(0,99)
Price to book ratio -0,467
(0,3079)
-0,60054***
(0,296)
Mutual fund flow 0,00288
(0,020)
0,00002
(0,00008)
Volatility of volatility
-
0,032
(0,043)
Constant 0.0064
(0,03)
0.556
(0,693)
2,052**
(0,860)
0,004
(0,024)

Num. Obs. 752 752 752 752
Adj. R
2
.1846 .2951 0.4628 0.4922

Reports the unstandardized coefficient, standard errors (in parentheses) and adjusted R
2
for the multiple
regressions of the in sample $RMSE on contemporaneous values of the predictor variables for the Heston and
Nandi GARCH. Model 1 refers to an AR(1) model for the $RMSE. Model 2 and Model 3 respectively add option
market factors and equity market factors to the set of predictor variables. Regression model 4 is equivalent to
Model 3, with all predictor variables first-differenced. . ***, ** and * denote significance at the 1%, 5% and 10%
level respectively.

41

model (HN model) could be explained by changes in economic conditions, option
sample characteristics and index properties. In Appendix 11, we provide the results of
the same regressions for the ABS model on the unrestricted sample of SPX options,
including ITM and DITM options, as additional evidence to support our previous
findings. Appendix 11 mainly confirms our previous results for the filtered sample of
OTM options: highly significant positive coefficients on the short- term interest rates,
yield spread, one-period log returns, total number of options and highly significant
negative coefficients on the price to book ratio and the dividend yield. Interestingly,
the adjusted R
2
of Model 4 also shows that our predictors have considerably more
explanatory power when the whole sample of options is considered, as their first-
differences explain roughly 30% of the variance for in-sample pricing errors.
Altogether our results confirm our initial intuition: pricing performance considerably
deteriorates in depressed financial markets. In the next section, we discuss our
findings for the out-of-sample prediction of option valuation errors for both models.
Out-of-sample time series regression for the ABS and HN model
The previous section aimed to explain the variation in option pricing performance for
our models over our 1996-2010 period. We showed that factors such as the dividend
yield, the total number of options, or the one-period log-returns were able to explain a
sizeable portion of the in sample variance in valuation error. Despite small
discrepancies between the regression results for the ABS and HN model, we showed
that an overall pattern emerges: periods of financial market trouble, characterized by
negative index returns, high demand for crash-protector puts, low institutional
sentiment, sudden decreases in dividend pay-out, low price to book ratios and
significant movement in interest rates were associated with periods of high valuation
errors. This prompts the question of whether our results hold for out-of-sample
pricing performance. In this section, our aim is twofold. First, we want to find out if
future pricing performance can be forecasted from the current vales of our economic
predictors. To that end, we use regression models 1,2 and 3 from the previous section,
with the OOS pricing error as the dependent variable and the lagged values of the
predictors as independent variables. Second, we also want to determine the proportion
of the OOS error due to changes in economic environment between the moment of
estimation and the time of evaluation. To calculate this amount of variance explained,
we use Model 4 of the previous section, with the OOS pricing error as the dependent
variable and the contemporaneous first-differences of the predictors as independent
variables. The results of these OOS regressions for the ABS and HN model are shown
in Table 7 and Table 8, respectively.

Forecasti ng the prici ng error one peri od ahead
As the results for the first three models in Table 7 show, almost all the forecasting
power for the ABS model is concentrated in the lagged first-difference of the error.
The coefficient estimate for this variable remains negative, which translates into the
following interpretation: a decrease in OOS pricing error over last week is likely to be
associated with an increase in OOS error over the coming week. Including the
characteristics of the option sample in our set of forecasting variables increases the
adjusted R
2
by a mere 1,8%, and adding the rest of the predictors explains an
additional 1% of the variance in ABS OOS errors. In terms of significance, the major
predictors of OOS error are the mean option price, the number of options worth less

42

than 1$, the CAPE ratio and the mean volume over past week. The individual bull-
bear spread is only marginally significant.
For the HN model, the results of Models 1 to 3 indicate that the lagged first-difference
of the OOS error has significantly less predictive power than for the ABS model: it
only explains 13% of the OOS error variance (compared to almost 22% for ABS).
However, the other predictors have considerably more forecasting power. Factors
such as the mean option price, the mean implied volatility, the one-period log returns,
the CAPE and the institutional bull-bear spread account for roughly 7% of the
variance. For both ABS and HN, the mean option price and the CAPE are significant
at the 5% level, and their coefficient estimates are respectively positive and negative.
Over our sample period, a higher mean option price is often associated with an overall
higher level of implied volatility or a concentration of the market demand in one
specific type of option, which is typical of periods of financial uncertainty, as she
showed earlier in Figure 13. The positive coefficient estimate therefore indicates that
when the mean option price is currently high, one can reasonably expect a higher
OOS valuation error in the coming week, because of expected changes on financial
markets. These changes can either be a rapidly climbing index level (in the wake of
financial bubbles), or a plummeting index price (following the burst of a bubble).
Once again, we stress that this interpretation is specific to our sample period.
Regarding the negative coefficient estimate on the CAPE, we provide a similar
explanation. Sudden decreases in the CAPE can either be due to increases in
cyclically adjusted earnings, or decreases in stock price. Since the CAPE is based on
the average inflation-adjusted earnings of 500 constituents over the previous 10 years,
the probability of a sharp increase in earnings is unlikely. We therefore argue that
sudden variations in CAPE are due to price fluctuations. The CAPE chart in
Appendix 8 seems to be in line with that claim: large changes in CAPE are
concentrated in the two recession periods. In light of that evidence, we postulate that
the negative coefficient on the CAPE is also attributable to the specificities of our
sample period. Large recent decreases in CAPE go along with worsening economic
conditions. This, in turn, leads to uncertainty on the stock and option markets, which
explains the predicted increase in option valuation error. Also note the positive
coefficient on the mean implied volatility for the HN model, which tends to
corroborate our previous arguments. Interestingly, the lagged log-returns appear to
have a negative, highly significant effect on future OOS performance. We argue that
this relationship is induced mechanically, since lagged log-returns are highly
negatively correlated with the lagged contemporaneous OOS error, which is itself
highly negatively correlated with its own lagged values.
Altogether, regression models one to three for both HN and ABS seem to indicate that
our set of predictors has a limited, yet significant, forecasting power for the expected
movements in pricing performance over the coming week. Over a one-week horizon,
variables such as the CAPE, the mean option price and the lagged error enable us to
predict a non -negligible fraction of the future variance in valuation errors. One must
however remain critical since we suspect some of the relationships discussed above to
be specific to the troubled nature of our sample period. Nevertheless, our regressions
for the ABS and HN models show similar results regarding the sign and significance
of the forecasting variable. Considering that the two time series of OOS errors rely on
radically different option model specifications, we are highly confident that our
results are in no way coincidental.

43

Table 7: Out of sample regressions for ABS pricing errors (filtered sample of OTM options)
Model 1 Model 2 Model 3 Model 4

Lagged error -.468**
(0,033)
-0,479***
(0,034)
-0,475***
(0,034)
-0,464***
(0,031)
Mean option price 0,071**
(0,034)
0,081**
(0,034)
0,005
(0,039)
Mean moneyness -0,651
(1,197)
0,496
(1,862)
5,908*
(3,219)
Mean maturity -0,002
(0,004)
-0,005
(0,004)
0,018***
(0,006)
Total number of options -2,342
(3,493)
-2,542
(3,555)
0,020***
(0,003)
Number of untraded options 4,158
(3,887)
4,071
(3,946)
-0,016***
(0,004)
Number of options under 1$ -11,199**
(5,376)
-11,999**
(5,624)
-0,018***
(0,006)
Put-call ratio -0,483
(0,545)
-0,457
(0,558)
0,590
(0,396)
Mean volume per contract 0,073
(0,176)
0,054
(0,176)
0,00041**
(0,0002)
Mean implied volatility 7,184
(4,457)
5,101
(5,649)
5,050
(5,54948)
VIX level -0,822
(1,128)
-
CAPE -14,769**
(6,583)
3,393
(5,956)
Log T-bill interest rate 53,554
(54,497)
-126,992**
(49,812)
Log yield spread 14,510
(43,735)
66,287
(40,881)
Log dividend yield 8,257
(11,774)
-179,807***
(55,739)
Bull-Bear spread institutions 0,844
(0,619)
-0,036***
(0,012)
Bull-Bear spread individuals -0,667*
(0,400)
0,005
(0,004)
Baker and Wurgler index -0,986
(1,491)
-0,230
(1,356)
Skew level -0,003
(0,012)
-0,009
(0,017)
SPX volume 0,022
(0,059)
-0,00008
(0,000)
SPX volume over past week 0,254**
(0,119)
0,00006
(0,00011)
One-period log returns 0,002
(0,032)
1,783
(1,98393)
Price to book ratio -0,794
(0,681)
1,275**
(0,632)
Mutual fund flow -0,023
(0,043)
0,00006
(0,00018)
Volatility of volatility
-
0,202**
(0,09277)
Constant 0.0087
(0,055)
1,2063
(1,346)
0,453
(1,909)
-0,008
(0,051)

Num. Obs. 751 751 751 751
Adj. R
2
.2164 .2342 0.2421 0.3304

Reports the unstandardized coefficient, standard errors (in parentheses) and adjusted R
2
for the multiple
regressions of the out-of-sample $RMSE on lagged values of the predictor variables for the ad hoc Black and
Scholes procedure. Model 1 refers to an AR(1) model for the $RMSE. Model 2 and Model 3 respectively add
option market factors and equity market factors to the set of predictor variables. Regression model 4 is similar to
Model 3, with the difference that all predictor variables are contemporaneous to the dependent variable and first-
differenced ***, ** and * denote significance at the 1%, 5% and 10% level respectively.


44

Table 8: Out of sample regressions for HN pricing errors (filtered sample of OTM options)
Model 1 Model 2 Model 3 Model 4

Lagged error

-.3693**
(0,034)
-0,399***
(0,035)
-0,327***
(0,037)
-0,302***
(0,032)
Mean option price 0,080***
(0,029)
0,063**
(0,029)
0,150***
(0,032)
Mean moneyness -0,991
(1,001)
1,975
(1,530)
-1,566
(2,601)
Mean maturity 0,00034
(0,003)
-0,00005
(0,0034)
-0,001
(0,005)
Total number of options 1,273
(2,895)
0,076
(2,892)
0,008***
(0,003)
Number of untraded options -5,001
(3,187)
-4,900
(3,170)
0,002
(0,003)
Number of options under 1$ -2,399
(4,485)
-3,185
(4,591)
0,001
(0,005)
Put-call ratio 0,0365
(0,4557)
-0,5279
(0,4581)
0,296
(0,321)
Mean volume per contract 0,093
(0,147)
0,108
(0,144)
0,0002***
(0,0001)
Mean implied volatility 10,331***
(3,726)
24,961***
(4,756)
-20,76***
(4,510)
VIX level 0,152
(0,926)
-
CAPE -13,955**
(5,410)
-0,878
(4,810)
Log T-bill interest rate -37,527
(44,536)
40,186
(40,270)
Log yield spread 2,349
(35,962)
60,952*
(33,055)
Log dividend yield 18,8415*
(9,6662)
-254,404***
(45,040)
Bull-Bear spread institutions 1,163**
(0,508)
-0,040***
(0,009)
Bull-Bear spread individuals 0,087
(0,330)
-0,0001
(0,0033)
Baker and Wurgler index -0,09207
(1,2248)
0,682
(1,096)
Skew level 0,00433
(0,01)
0,001
(0,014)
SPX volume -0,002
(0,048)
0,00002
(0,00004)
SPX volume over past week 0,027
(0,098)
0,00010
(0,00009)
One-period log returns 0,16651***
(0,0278)
-12,37***
(1,645)
Price to book ratio -0,4122
(0,5578)
-0,956*
(0,511)
Mutual fund flow -0,0081
(0,0354)
0,00006
(0,00014)
Volatility of volatility
-
0,26779***
(0,0747)
Constant 0.0075
(0,0462)
0,892
(1,125)
-2,155
(1,567)
0,0001
(0,0411)

Num. Obs. 751 751 751 751
Adj. R
2
.1352 .1649 0.2036 0.3179

Reports the unstandardized coefficient, standard errors (in parentheses) and adjusted R
2
for the multiple
regressions of the out-of-sample $RMSE on lagged values of the predictor variables for the Heston and Nandi
GARCH. Model 1 refers to an AR(1) model for the $RMSE. Model 2 and Model 3 respectively add option market
factors and equity market factors to the set of predictor variables. Regression model 4 is similar to Model 3, with
the difference that all predictor variables are contemporaneous to the dependent variable and first-differenced
***, ** and * denote significance at the 1%, 5% and 10% level respectively.

45

Infl uence of period-to-peri od market fluctuations on OOS error
The last column of Table 7 and Table 8 allows us to study another set of relationships.
In Model 4, we determine the amount of variance in OOS error that can be explained
from changes in the economic environment between the point in time at which the
parameters of the model are estimated, and the time at which options are priced
(exactly one week later). We stress out that for Model 4, the predictors are first-
differenced, but also contemporaneous to the dependent variable. Noteworthy features
shared by both models in Table 7 and Table 8 are the positive coefficients on the total
number of options, mean volume per contract, volatility of volatility and the negative
coefficients on the institutional bull-bear spread and the dividend yield.
To interpret those results, let us consider a hypothetical situation for which we
estimate the ABS (GARCH) parameters for a given day, with the intention of using
these parameters to price options in the next period. Our results indicate that if the
number of contracts available on the options market and the mean option price
increase between the current and the next period, higher OOS valuation errors are
likely to follow.
Similarly, an increase in the vol-of-vol between periods will lead to a higher level of
mispricing in the next week. We defined volatility of volatility as the standard
deviation of the implied volatility of ATM options over the last 20 days. First
interpretation is that an increase in vol-of-vol is typical for a more troubled market,
with gradually raising levels of uncertainty for the short-term future and an irregular
shape for the implied volatility surface. Although we expect the effect of vol-of-vol to
be stronger for the ABS model (for which the implied volatility surface is used as an
input), our results show that this is not the case. Out of curiosity, we narrowed the
estimation period for the vol-of-vol from 20 to 9 days and estimated Model 4 again.
The results for both models were unequivocal: the coefficient on the vol-of-vol
becomes larger and highly significant for both models, even more so for the ABS
model (t = 11.S4, p = 1.S 1u
-2
), for which the R
2
jumps from 33% to 43%. This
supports our intuition that the influence of vol-of-vol proxies for a deterioration of
economic conditions over the week between estimation and evaluation. As a second
interpretation, we suggest that high vol-of-vol might translate into a radical change in
the variance process between two subsequent weeks, due to some major event
between estimation and evaluation. The parameters estimated in the previous period,
which at that time might have led to good in-sample performance, would therefore
lead to a poor fit at the time of evaluation.

The negative coefficient on the institutional bull-bear spread is also in line with this
reasoning, since a decrease in institutional sentiment between estimation and
evaluation is associated with deterioration in OOS pricing performance. Finally, the
negative, highly significant coefficient on the dividend yield relates to the argument
we made previously using Figure 12: a large decrease in the dividend yield over short
periods is indicative of financial turmoil, and it is often associated with unusual
changes in the shape of the implied volatility function that lead to higher valuation
errors. Another way to look at this phenomenon is by considering the persistency of
the option pricing model parameters: o
0
o
1
o
2
o
3
o
4
o
5
for ABS and o
-
[
-
y
-

-

during crisis periods.


46

Appendix 10 shows the time series of the parameter o
3
(linear maturity term) for the
ABS model, as well as that the series y
-
(risk-neutral skewness) for the HN GARCH.
Both time series exhibit considerably more variations around 2000 and 2008, which
illustrates our point. Since OOS valuations relies on past week estimates for the
models parameter, a high week-to-week volatility for these parameters results in less
accurate valuation. As confirmatory evidence, we provide the results of these
regressions on our unrestricted sample in Appendix 12 for the ABS model. Without
discussing these results in depth, we argue that a similar pattern as that we just
described emerges when ITM and DITM options are included in the sample. Most of
the significant coefficient estimates for our filtered sample of OTM options remain
significant and of the same sign after including in-the-money options, with the
exception of the mean option price, for which the coefficient in Model 4 becomes
negative. Interestingly, mean maturity and moneyness both become highly significant
and positive in Model 4.




47

Conclusions
Throughout this study, we have tried to fill a void in the option pricing literature.
Since the introduction of the Black-Scholes model in 1973, much attention had been
devoted to finding the best performing option-pricing model among the multitude of
existing alternative models. From binomial trees to stochastic volatility models,
academics and practitioners have progressively developed an impressive amount of
ever more accurate models. Oddly enough, to the extent of our knowledge no study
has ever focused on common cyclical performance patterns across models. Could
diametrically different models share a common trend in pricing performance over
time, and if so, can this shared variation be explained to some extent? These
questions were the guiding thread of our research.

This study focuses on two widely accepted option-pricing models, the ad hoc Black
and Scholes, or practitioners model, and the GARCH model with Gaussian
innovations developed by Heston and Nandi (2000). As first step of our study, we
derived the times series of the pricing error for both models, using fourteen years of
weekly option and index data for the S&P 500 index. This allowed us to observe a
strong common pattern of cyclicality in option pricing performance over our sample
period. For our two models, both in-sample and out-of-sample valuation errors
reached considerably higher levels during periods of financial turmoil. Although it
was not the primary aim of our research, we were also able to compare our results
with those of the option pricing literature. We found that our findings are in line with
those presented in Heston and Nandi (2000) and Barone-Adesi, Engel and Mancini
(2008): the HN GARCH model systematically yields lower valuation errors than the
ad hoc Black and Scholes model of Dumas, Fleming and Whaley (1998). We also
documented that a modified version of the ABS model described in Bollen and
Whaley (2004) was able to perform even better over our sample period. In order to
fully explain the overall superior pricing accuracy of the ad hoc Black and Scholes
model, we derived the time series of the pricing error for nine option categories based
on option moneyness and time to expiration. This allowed us to observe that the HN
GARCH model systematically fails to deliver performance for short-maturity options,
even more so when these options are out-of-the-money.

Coming back to our original guiding thread, we then shifted our focus to finding
underlying factors that could explain the cyclicality observed for our time series of
valuation errors. An extensive review of the empirical finance literature yielded a set
of twenty-five predictors related either to our option sample, to characteristics of the
S&P 500 index, or associated with global economic conditions. A series of in-sample
and out-of-sample time series regressions then allowed us to determine the impact of
our various predictors on pricing performance. Our regression results for both models
are unequivocal and they lead to the same general conclusion: pricing performance
deteriorates along with worsening economic conditions. Our regression results
especially indicate that over our sample period, crisis periods characterized by
negative index returns, high demand for crash-protective put options, declining
institutional sentiment, sudden reductions in dividend pay-out, low price to book
ratios and significant movement in interest rates coincide with periods of high
valuation errors. This conclusion holds for both out-of-sample and in-sample pricing
performance. Our research contributes to the existing literature in several ways.

48

To the extent of our knowledge, this is the first attempt to study the time series
behaviour of the pricing error across option-pricing models. Over our fifteen-year
sample period, we were able to show that, no matter the model, performance has a
discernable time component. For two diametrically different models, we showed that
the level of valuation error varies considerably over longer periods of time and that it
is highly dependent on current economic conditions. We therefore advocate for taking
this time component into account in future research.

Moreover, we identify a set of economic indicators and option market characteristics
able to explain part of the cyclical nature of option pricing errors. We show that the
cycles in pricing performance are mainly affected by variables representative of
general financial conditions, such as short-term interest rates, the shape of the yield
curve for government bonds, movements in institutional sentiment as well as dividend
yields and price-earnings ratios for the S&P 500 index. Our results indicate that, as
for many other asset pricing models in empirical finance, the performance of option
pricing models is significantly worse and more volatile around market crashes, due to
the erratic behaviour of the stock and options market in these troubled times. We also
showed that the parameters used as input in the option pricing-models tend to be more
volatile during crises periods, and lead to deteriorating out-of-sample performance,
due to large fluctuations between subsequent periods. This underlines the importance
of frequent model recalibration to account for variations in economic indicators such
as interest rates or institutional demand for crash-protective put options. Our last
remark is of high relevance for practitioners who use these option-trading models on a
regular basis as a professional tool.

In addition, the time series for the valuation error prove to be relatively sticky. The
high levels of error observed in the midst of recession periods are not confined to the
peaks of the associated financial crises; they already appear in the preceding months
and remain present for a long time afterwards. As a result, our results show an
alternation of relatively long periods of high and low valuation errors. At any point in
time, it is therefore possible to make reasonable predictions for the level of option
pricing error in the near future, from the current values of the error.

Our results also clearly show that, although the general level of error increases for all
models in depressed financial markets, some models might perform better than others
in crisis periods. In light of that evidence, we argue that comparing model
performance over short periods of time of two years or three years, as is usually done
in the existing literature, only offers limited insight. In our opinion, a fair comparison
between option-pricing models should account for the fact that the relative
outperformance of a model over another might only be true for a specific time period.

Finally, although it was not our primary aim, we also indirectly contributed to the
option pricing literature by showing that the performance of deterministic volatility
models, such as the ad hoc Black and Scholes model, is highly dependent on model
specification. Our results indicate that variable transformation in the deterministic
volatility function, such as the replacement of strike price by relative moneyness, lead
to considerable improvements in pricing performance. We showed that the modified
ad hoc Black and Scholes presented in Bollen and Whaley (2004) significantly
outperforms the Heston and Nandi GARCH model during crisis periods. This is in
line with the compelling amount of evidence showing that the ad hoc Black and

49

Scholes model, although it is simple and theoretically inconsistent, is a remarkable
tool to price options. In addition to these contributions, we also note a few
shortcomings and suggestions for further research

First, we note that despite the attention devoted to colinearity and stationarity issues
in our time-series regressions, our results have to be considered with caution. Many of
the variables used as predictors of option pricing performance are weakly or
moderately correlated, which might slightly inflate the portion of variance explained.
We accept this limitation, and expect future research to elucidate this issue and
provide further evidence for the relationships we highlighted in our research.

We also discuss several minor issues regarding the numerical implementation of our
option pricing models. Despite the great care with which we implemented the
calibration procedure, we suspect that common optimization issues, such as local
minima for the root mean square pricing error, might slightly affect our results. To
alleviate this concern, we propose the implementation of a genetic algorithm. A
second issue relates to the quadratic interpolation polynomials we used to fit the yield
curve. Although they provide fairly accurate estimates most of the time, these
polynomials exhibit a poor fit when the yield curve deviates from its usual shape and
becomes inverted. We recommend the use of spline interpolants, which would
guarantee an excellent fit in all situations.

Finally, this research was carried out using two option pricing models and mostly
weekly data. An interesting extension of our work would be to use our approach with
daily data, or to derive the time-series of pricing error for other alternative option
pricing models. We are confident that our results are not confined to the specifics of
our empirical methodology, and we trust that future evidence will contribute to shed
more light on the global patterns in pricing performance we unveiled in this research.




50

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53

Appendix



Appendix 2: First-differenced time series of the dollar root mean square pricing error for the ABS and HN
model

Appendix 1: Average pricing error by option category for the ABS model (including ITM options)
Appendix 1 shows the yearly mean $RMSE obtained from the ad hoc Black and Scholes model across option
categories for the whole sample of SPX options (including in-the-money options). For concision, we only show
the results one every two year. Maturity and moneyness categories are as described in the section describing the
option data. In-the-money options are defined by the following bounds for the option delta: u.62S < A
C
u.87S
for calls and u.87S < A
P
u.62S for puts. The bounds for deep-in-the-money options are u.87S < A
C

u.8 for calls and u.8 < A
P
u.87S for puts. The mean yearly pricing error is highest for ATM long-
maturity options in the early years of our sample period. The $RMSE decreases asymptotically as time to
expiration decreases. It also decreases for options located on the far ends of the moneyness spectrum (DOTM or
DITM). Since the dot-com bubble, the highest level of mispricing achieved by the ABS model is for DOTM
options with long time to expiration.

54

Appendix 3: Out of sample differences in ABS and HN pricing errors




Appendix 4: Stationarity and unit root testing
In this research we restrict our focus to weak-sense stationarity (WSS). Formally, for
a time series variable
t
to be weak-sense stationary, the following conditions are
required:
In other words, WSS requires the first two moments of the variable
t
to stay constant
over time. Looking back at the pricing errors series in Figure 5 or the charts of the
error forecasting variables in Appendix 8, it is clear that they behave like stochastic
processes: their discrete variations between two consecutive weeks appear to be
random. What is unclear however, is whether these processes are stationary. In order
to shed light on the issue of stationarity, we carry out unit root tests on our two time
series. We rely on Augmented Dickey-Fuller (ADF) tests. The ADF unit root test fits
the time series tested for stationarity
t
to the general model in equation ( 21 ).
Depending on the values of the parameters o and [, equation ( 21 ) can either model a
trend stationary process ([ u), a random walk without drift ([ = u, o = u), or a
random walk with a drift ([ = u, o u).
The number of lags p defines the order of the autoregressive process. Supposing that
o, p and [ are provided, the parameters of the model are estimated for the series
t
,
and the null hypothesis of the presence of a unit root y = u is tested against the
alternative hypothesis y < 1. The outcome of the unit root test is highly dependent on
the choice of the values for o, p and [, and it is therefore of utmost importance to use
appropriate values. To choose these parameters adequately, we rely on the following
step-by-step methodology:
1) First, we choose the appropriate model for the series
t
tested for stationarity:
autoregressive (AR), autoregressive with drift (ARD), or trend stationary (TS).
We observe the time series chart of
t
and determine whether or not the series
is trending, and whether it fluctuates around a zero mean. For example, the
error series for the ABS model, shown in Figure 5, has a non-zero constant



(
t
) = p
ai(
t
) = o
2
(
t
,
t-
) = y

( 20 )

A
t
= o +[t +y
t-1
+
1
A
t-1
++
-1

t-+1
+
t

( 21 )

55

drift term and does not follow any definite upward or downward trend over
our sample period. We therefore categorize it as ARD.

2) The second step is to choose the appropriate number of lags to be considered
in equation ( 21 ). We rely on the method described in Ng and Perron (1995,
2001), and start by calculating the maximum lag length p

. Schwert (1989)
suggests the following rule of thumb for determining p

= Rc _12 _
I
1uu
]
0.25
_

3) ADF unit roots tests are carried out for integer values p ranging from 1 to
p

. We select the value of p that minimizes the following criterion, where

AIC is the Akaike information criterion, and BIC and HQC are the Bayesian
and Hannan-Quinn information criteria.
p

= aig min
<
mcx
(AIC +BIC +EC)

Although these individual information criteria usually point towards the same
optimal lag length p

, we choose to use a consensus-based measure.

4) If the test statistic fails to reject the null hypothesis of non-stationarity, we use
first-differences to induce stationary behaviour. If the tested series
t
is trend-
stationary, we use linear regression to remove the trend.







Appendix 5: Result of the Engle-Granger and Johansen cointegration tests for the ABS and HN in-sample
pricing errors

Engle-Granger cointegration test

Dep.Variable Ind. Variable p

Critical EG value ADF test statistic P value

$RMSE (ABS) $RMSE (HN) 7 -2.8664 -5.5110

<0.001


Johansen cointegration test

p

Hypotheses Statistic Critical value P value Eigenvalue

4 r = u 63.1520 20.2619 <0.001 0.0662
r 1 11.6526 9.1644 0.0151 0.0157






56

Appendix 6: Contemporaneous correlations between the four proxies of investor sentiment
BW BBins BBind MFF
Baker and Wurgler 1,00 - - -
Bull-Bear spread (institutions) -0,15*** 1,00 - -
Bull-Bear spread (individuals) -0,09*** 0,34*** 1,00 -
Mutual fund flow -0,11*** 0,52*** 0,17*** 1,00
*** Significant at the 1% level. BW is the Baker and Wurgler sentiment index, BBins and
BBind are the institutional and individual bull-bear spreads and MFF are the mutual fund
net flows



Appendix 7: ADF test results for predictor variables and overview of variable transformations
Predictor p

Model
ADF test
statistic
P value Treatment
Mean option price 20 ARD -3,42 0,011 -
Mean option moneyness 3 ARD -4,17 0,001 -
Mean option maturity 20 ARD -3,88 0,003 -
Total number of options 20 TS -0,70 0,972 First-difference
Number of untraded option contracts 20 TS -1,40 0,861 First-difference
Number of options worth less than
1$
20 TS -1,16 0,916 First-difference
Put-call ratio 5 ARD -7,28 0,001 -
Average number of trades per
contract
20 TS -2,17 0,508 First-difference
Average option implied volatility 1 ARD -3,20 0,021 -
VIX level 13 ARD -3,01 0,035 -
CAPE 20 TS -3,16 0,095 First-difference
Log 90-days T-bill interest rate 1 TS -1,11 0,926 First-difference
Log yield spread 1 ARD -2,24 0,193 First-difference
Log dividend yield 1 ARD -4,96 0,001 -
Past 10 days SPX volatility 2 ARD -6,24 0,001 -
Bull-bear spread (institutions) 17 ARD -3,19 0,021 -
Bull-bear spread (individuals) 20 ARD -3,95 0,002 -
Baker and Wurgler sentiment index 14 ARD -2,29 0,174 First-difference
SKEW level 18 TS -3,87 0,014 Detrending
Number of SPX shares traded 20 TS -3,25 0,075 First-difference
Average SPX volume over the past
week
20 TS -2,53 0,329 First-difference
Log one-period returns 1 AR -20,25 0,001 -
Price to book ratio 1 TS -2,89 0,166 First-difference
Mutual fund net flows 20 ARD -3,39 0,012 -
Volatility of volatility 2 ARD -6,14 0,001 -

57


Appendix 8: Time series of error pricing predictors (untransformed series)
Appendix 8 shows the time series of the untransformed predictor variables over our sample period 1996-
2010. Predictors related to the characteristics of our option sample, such as mean option moneyness or
option contracts volume, are shown for our filtered sample of OTM options. The deviations from put-call
parity (last chart) are derived from the unrestricted sample, including ITM and ATM options. The data on
the CAPE ratio is obtained from Robert Schillers website and the interest rates and yield spreads are from
the Federal Reserve. The data on investors sentiment is retrieved from Investment Company Institute
(mutual fund flows), Investor Intelligence (institutional bull-bear spread), the American Association of
Individual Investors (individual bull-bear spread) and Jeffrey Wurglers website (Baker and Wurgler
sentiment index).

58






59

Appendix 9: Partial Autocorrelation functions of the first-differenced pricing errors for the ABS and HN
models



Appendix 10: Parameter volatility over the sample period 1996-2010




60

Appendix 11: In sample regressions for the ABS error (full spectrum of option moneyness)
Model 1 Model 2 Model 3 Model 4

Lagged error -.424**
(0,033)
-0,439***
(0,032)
-0,439***
(0,032)
-0,325***
(0,027)
Mean option price 0,0091***
(0,002)
-0,010***
(0,003)
-0,022***
(0,003)
Mean moneyness -4.476***
(0,861)
7,227***
(1,633)
17,535***
(1,296)
Mean maturity 0,0079***
(0,002)
0,006**
(0,003)
0,010***
(0,003)
Total number of options 1,911
(1,380)
2,260
(1,388)
0,003***
(0,001)
Number of untraded options --1,4521
(1,629)
-1,699
(1,631)
0,001
(0,001)
Number of options under 1$ -7,024**
(2,952)
-7,459**
(3,034)
-0,016***
(0,003)
Put-call ratio -0,435
(0,433)
0,582
(0,435)
0,057
(0,271)
Mean volume per contract -0,0017
(0,159)
0,053
(0,158)
0,00008
(0,0001)
Mean implied volatility 0,2738
(0,910)
0,942
(3,213)
0,929
(2,512)
VIX level 0,510
(2,488)
-
CAPE 3,415
(4,262)
3,074
(3,391)
Log T-bill interest rate 97,303***
(33,822
113,4***
(28,117)
Log yield spread 89,484***
(27,626)
88,60***
(23,1)
Log dividend yield 2,942
(7,360)
-279,70***
(31,97)
Bull-Bear spread institutions 1,106***
(0,394)
0,004
(0,01)
Bull-Bear spread individuals -0,189
(0,261)
0,005**
(0,002)
Baker and Wurgler index 0,876
(0,961)
0,454
(0,774)
Skew level 0,011
(0,008)
0,016*
(0,010)
SPX volume -0,043
(0,038)
-0,00002
(0,00003)
SPX volume over past week -0,127*
(0,076)
-0,00010
(0,00006)
One-period log returns 0,032*
(0,017)
6,131***
(1,083)
Price to book ratio -1,121**
(0,435)
-1,052***
(0,361)
Mutual fund flow 0,013
(0,028)
0,000
(0,0001)
Volatility of volatility
-
-0,039
(0,052)
Constant 0.0016
(0,036)
5.106***
(0,891)
-7,994***
(1,741)
0,005
(0,029)

Num. Obs. 751 751 751 751
Adj. R
2
.1782 .2293 0.2535 0.4772

Reports the unstandardized coefficient, standard errors (in parentheses) and adjusted R
2
for the multiple
regressions of the in sample $RMSE on contemporaneous values of the predictor variables for the ad hoc Black
and Scholes procedure. Model 1 refers to an AR(1) model for the $RMSE. Model 2 and Model 3 respectively add
option market factors and equity market factors to the set of predictor variables. Regression model 4 is equivalent
to Model 3, with all predictor variables first-differenced. . ***, ** and * denote significance at the 1%, 5% and
10% level respectively.


61

Appendix 12: Out-of-sample regressions for ABS pricing error (full spectrum of option moneyness)
Model 1 Model 2 Model 3 Model 4

Lagged error -.424**
(0,033)
-0,460***
(0,035)
-0,457***
(0,035)
-0,415***
(0,030)
Mean option price 0,0038
(0,0039)
0,0039
(0,0050)
-0,0247***
(0,0052)
Mean moneyness -1,53
(1,41)
-3,15
(2,70)
17,19***
(2,18)
Mean maturity -0,0011
(0,0038)
-0,0015
(0,0042)
0,021***
(0,005)
Total number of options -1,493
(2,287)
-2,083
(2,322)
0,0139***
(0,0021)
Number of untraded options 1,89
(2,71)
2,1871
(2,73)
-0,0102***
(0,0025)
Number of options under 1$ -17,23***
(4,86)
-18,1844***
(5,06)
-0,0272***
(0,0047)
Put-call ratio -0,0621
(0,7046)
-0,4838
(0,7122)
0,5281
(0,4649)
Mean volume per contract 0,0736
(0,2604)
-0,0206
(0,2604)
0,0006**
(0,0002)
Mean implied volatility -0,888
(1,481)
-0,209
(5,263)
4,327
(4,310)
VIX level -0,504
(4,075)
-
CAPE -16,54**
(6,97)
4,665
(5,826)
Log T-bill interest rate 19,69
(55,58)
-87,51*
(48,24)
Log yield spread -9,51
(45,33)
109,64***
(39,58)
Log dividend yield 16,1110
(12,059)
-293,31***
(54,84)
Bull-Bear spread institutions 0,6210
(0,6461)
-0,0224**
(0,0114)
Bull-Bear spread individuals -0,9091*
(0,4268)
0,0064
(0,0039)
Baker and Wurgler index -0,3285
(1,5732)
-0,0305
(1,3272)
Skew level -0,0120
(0,0129)
0,0100
(0,0169)
SPX volume -0,00979
(0,0616)
-0,0001
(0,0001)
SPX volume over past week 0,1980
(0,1243)
0,00005
(0,00011)
One-period log returns -0,0490*
(0,0271)
4,8702***
(1,8505)
Price to book ratio -0,7655
(0,7129)
0,6054
(0,6197)
Mutual fund flow -0,0248
(0,0452)
0,0001
(0,0002)
Volatility of volatility
-
0,1371
(0,0905)
Constant 0.0016
(0,036)
1.6402
(1,463)
3,224
(2.878)
-0,0045
(-0,0498)

Num. Obs. 751 751 751 751
Adj. R
2
.2052 .2164 0.2323 0.4097

Reports the unstandardized coefficient, standard errors (in parentheses) and adjusted R
2
for the multiple
regressions of the out of sample sample $RMSE on contemporaneous values of the predictor variables for the ad
hoc Black and Scholes procedure. Model 1 refers to an AR(1) model for the $RMSE. Model 2 and Model 3
respectively add option market factors and equity market factors to the set of predictor variables. Regression
model 4 is equivalent to Model 3, with all predictor variables first-differenced. . ***, ** and * denote significance
at the 1%, 5% and 10% level respectively.