Option pricing with overnight and intraday volatility

Efficiently exploiting the volatility information contained in price variations is important for pricing options and other derivatives. In this study, we develop a new and flexible option-pricing model that explicitly specifies the joint dynamics of overnight and intraday returns. The application of multivariate Edgeworth-Sargan density enables us to derive analytical approximations for option valuation formulas. Empirically, the model improves significantly upon benchmark models using S & P 500 index options. In particular, its separate modeling of intraday and overnight return volatility leads to an out-of-sample gain of 7.24% in pricing accuracy compared with the modeling of the close-to-close return volatility as a whole. The improvements are more pronounced during highly volatile periods.