N° 19-49: Risk Premia and Lévy Jumps: Theory and Evidence

To study jump and volatility risk premia in asset returns, we develop a novel class of time-changed Lévy models. The models are characterized by flexible Lévy measures, and allow consistent estimation under physical and risk neutral measures. To operationalize the models, we introduce a simple and rigorous filtering procedure to recover the unobservable time changes. An extensive time series and option pricing analysis of 16 time-changed Lévy models shows that infinite activity processes carry significant jump risk premia, and largely outperform many finite activity processes.