Understanding the Structure of Volatility Risks

Abstract

Studies of asset returns time-series provide strong evidence that at least two stochastic factors drive volatility. This paper investigates whether two volatility risks are priced in the stock option market and estimates volatility risk prices in a cross-section of stock option returns. The paper finds that the risk of changes in short-term volatility is significantly negatively priced, which agrees with previous studies of the pricing of a single volatility risk. The paper finds also that a second volatility risk, embedded in longer-term volatility is significantly positively priced. The difference in the pricing of short- and long-term volatility risks is economically significant - option combinations allowing investors to sell short-term volatility and buy long-term volatility offer average profits up to 20% per month.