How Does Economic Policy Uncertainty Reshape Option Pricing?

Abstract

Economic policy uncertainty (EPU) is a critical yet often neglected factor in derivatives pricing, leading to systematic biases in existing valuation frameworks. This study proposes an advanced pricing model that explicitly incorporates a stochastic EPU factor with a regime-switching long-term mean into the stochastic volatility framework. The principal theoretical contribution of this research is a closed-form analytical pricing formula for European options, which successfully overcomes the challenges of multiple stochastic factors and achieves substantial computational advantages over traditional numerical methods such as the Monte-Carlo simulation. A preliminary empirical study using SSE 50 ETF option data demonstrates the model's superior pricing performance compared to other benchmarks.