Option Valuation with Volatility Components, Fat Tails, and Nonmonotonic Pricing Kernels*

We nest multiple volatility components, fat tails and a U-shaped pricing kernel in a single option model and compare their contribution to describing returns and option data. All three features lead to statistically signi…cant model improvements. A U-shaped pricing kernel is economically most important and improves option …t by 17% on average and more so for two-factor models. A second volatility component improves the option …t by 9% on average. Fat tails improve option …t by just over 4% on average, but more so when a U-shaped pricing kernel is applied. Overall these three model features are complements rather than substitutes: the importance of one feature increases in conjunction with the others. JEL Classi…cation: G12 Keywords: Volatility components; fat tails; jumps; pricing kernel. We are grateful to our EFA discussant Fulvio Pegoraro, Alex Potapchik and Lars Stentoft for very helpful remarks. Christo¤ersen acknowledges …nancial assistance from Bank of Canada, GRI and SSHRC. Correspondence to: Steven Heston, R.H. Smith School of Business, University of Maryland, 4447 Van Munching Hall, College Park, MD 20742; Tel: (301) 405-9686; E-mail: sheston@rhsmith.umd.edu.