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M. Serban, J. Lehoczky, and D. Seppi, “Cross-Sectional Stock Option Pricing and Factor Models of Returns,” (Paper presented at the annual meeting of the AFA, San Francisco, January 2012).

M. Serban, J. Lehoczky, and D. Seppi, “Cross-Sectional Stock Option Pricing and Factor Models of Returns,” (Paper presented at the annual meeting of the AFA, San Francisco, January 2012).

Abstract: Is the pricing of index and individual stock options consistent with a factor model of stock returns? To answer this question, we use returns and option prices for a cross-section of stocks and a market index to carry out an integrated estimation of a multivariate stochastic volatility models with systematic factors and idiosyncratic return components. In particular, we estimate both the objective and risk neutral (RN) dynamics of the model using particle filter techniques. For a one-factor “market model” of stock returns we find that 1) the market (S&P 500) betas of individual stocks are similar under the objective and RN measures, 2) there is a statistically and economically important common factor in the volatility of idiosyncratic returns, 3) the factor loadings of individual stocks on this common component of idiosyncratic volatility are also similar under the objective and RN measures, and 4) both market and common idiosyncratic volatility appear to be priced in option prices.