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The Pricing of Volatility and Jump Risks in the Cross-Section of Index Option Returns

Published online by Cambridge University Press:  07 April 2022

Guanglian Hu Open the ORCID record for Guanglian Hu [Opens in a new window]  and
Yuguo Liu
Guanglian Hu*
Affiliation:
University of Sydney Discipline of Finance
Yuguo Liu
Affiliation:
University of Houston Department of Finance mailsforhugo@gmail.com
*
guanglian.hu@sydney.edu.au (corresponding author)
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Abstract

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Existing studies relate the puzzling low average returns on out-of-the-money (OTM) index call and put options to nonstandard preferences. We argue the low option returns are primarily due to the pricing of market volatility risk. When volatility risk is priced, expected option returns match the realized average option returns. Moreover, consistent with its theoretical effect on expected option returns, the volatility risk premium is positively related to future index option returns and this relationship is stronger for OTM options and at-the-money straddles. Finally, we find the jump risk premium contributes to some portion of OTM put option returns.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 57 , Issue 6 , September 2022 , pp. 2385 - 2411
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (https://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2022. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank Anandi Banerjee, David Bates (discussant), Jim Campasano (discussant), Jennifer Conrad (the editor), Christian Dorion, Hitesh Doshi, Bjorn Eraker, Neal Galpin, Quan Gan, Bing Han, Christopher Jones, Praveen Kumar, Gang Li (discussant), Hamish Malloch, Dmitriy Muravyev, Neil Pearson, Alessio Saretto (the referee), Sang Byung Seo, Longfei Shang (discussant), Aurelio Vasquez, and James Yae, seminar participants at the University of Houston, the University of Sydney, Monash University, the 2016 FMA PhD Student Session, the IFSID Fifth Conference on Derivatives, 2019 Derivative Markets Conference, 2019 FMA, 32nd Australasian Finance & Banking Conference, and Cancun Derivatives Workshop 2020, and especially Kris Jacobs for helpful comments.

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