The Pricing of Market and Idiosyncratic Jump and Volatility Risks

Abstract

This paper analyzes the risk-return relation of different variance components in the cross-section of option and stock returns. Using option portfolios that have a constant exposure to either jump or diffusive risk, I decompose variance risk into four components: market volatility risk, idiosyncratic volatility risk, market jump risk, and idiosyncratic jump risk. The lion’s share of stocks' variance risk is paid for the idiosyncratic components, with Sharpe Ratios of -3.44 for idiosyncratic jump risk and 2.15 for idiosyncratic volatility risk. While all four components are at play when stocks earn negative returns, idiosyncratic jump and volatility risks are most important to explain positive returns. In addition, stocks that have higher idiosyncratic jump risk premiums earn higher future returns.