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.