What is beneath the surface? Option pricing with multifrequency latent states

Abstract We introduce a tractable class of multi-factor price processes with regime-switching stochastic volatility and jumps, which flexibly adapt to changing market conditions and permit fast option pricing. A small set of structural parameters, whose dimension is invariant to the number of factors, fully specifies the joint dynamics of the underlying asset and options implied volatility surface. We develop a novel particle filter for efficiently extracting the latent state from joint S&P 500 returns and options data. The model outperforms standard benchmarks in- and out-of-sample, and remains robust even in the wake of seemingly large discontinuities such as the recent financial crisis.