Abstract
This study demonstrates empirically the impact of stock return autocorrelation on the prices of individual equity option. The option prices are characterized by the level and slope of implied volatility curves, and the stock return autocorrelation is measured by variance ratio and first-order serial return autocorrelation. Using a large sample of U.S. stocks, we show that there is a clear link between stock return autocorrelation and individual equity option prices: a higher stock return autocorrelation leads to a lower level of implied volatility (compared to realized volatility) and a steeper implied volatility curve. The stock return autocorrelation is more important in explaining the level of implied volatility curve for relatively small stocks. The relation between stock return autocorrelation and option price structure is more pronounced when market is volatile, especially during financial crisis. The stock return autocorrelation is more important in explaining the level of implied volatility curve for relatively small stocks. Thus, stock return autocorrelation can help differentiate the price structure across individual equity options.
Highlights
Empirical studies have uncovered some intriguing features, among others, of index and individual equity option prices: (i) the option implied volatility is higher than the realized volatility (e.g., Rubinstein, 1994; Jackwerth & Rubinsten, 1996; Carr & Wu, 2009; Duan & Wei, 2009), and (ii) the implied volatility curve consistently exhibits pronounced smile effects
The stock return autocorrelation is more important in explaining the level of implied volatility curve for relatively small stocks
We fill the gap by investigating the impact of stock return autocorrelation on the individual equity option price structure and demonstrate a clear link between them
Summary
Empirical studies have uncovered some intriguing features, among others, of index and individual equity option prices: (i) the option implied volatility is higher than the realized volatility (e.g., Rubinstein, 1994; Jackwerth & Rubinsten, 1996; Carr & Wu, 2009; Duan & Wei, 2009), and (ii) the implied volatility curve consistently exhibits pronounced smile effects (see Jackwerth & Rubinsten, 1996; Bates, 2000; Bakshi et al, 2003; Yan, 2011; Xing et al, 2011). The evidence of persistence autocorrelation in asset returns of both the short-term (see, for example, Lo and Mackinlay (1988, 1990), Conrad and Kaul (1988)) and long-term period (see, for example, Fama and French (1988) and Poterba and Summers (1988)) contradicts the assumption made in the option pricing models Following this line of research, literature documents that stock return autocorrelation enters into the option pricing formula through www.scholink.org/ojs/index.php/jbtp. Vol 9, No 1, 2021 adjustments in volatility and/or expected asset price (Lo and Wang (1995), Jokivuolle (1998), Mezrin (2004), Liao and Chen (2006), etc.) It is an empirical question, as to the extent that stock return autocorrelation affects option prices.
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