Christian Dorion, McGill University

Abstract:
We introduce a dynamic volatility model in which stock market volatility varies around a time-varying fundamental level. This fundamental level is determined by macroeconomic risk, quantified using a MIDAS structure to account for changes in the recently introduced ADS Business Conditions Index. The new model outperforms the benchmark in fitting asset returns and in pricing options, especially around the 1990-1991 and 2001 recessions.

The benchmark model exhibits a counter-cyclical optionvaluation bias across all maturities and moneyness levels, and the newly introduced model removes this cyclicality by allowing the conditional expected level of volatility to evolve with business conditions. We extract the volatility premium implied by the model and find that an economically significant 13% of its variation through time can be explained by the impact of macroeconomic risk.