Cross-section Of Option Returns Research Articles

Moneyness, Underlying Asset Volatility, and the Cross-Section of Option Returns

Abstract We study the effect of an asset’s volatility on the expected returns of European options on the asset. Deriving predictions from a stochastic discount factor model, we show that the effect depends on whether variations in the asset’s volatility are driven by systematic or idiosyncratic volatility. While idiosyncratic-volatility-induced variations only affect the option elasticity, systematic-volatility-induced variations also oppositely affect the expected return of the asset. Since the expected asset return (elasticity) effect dominates for options with more linear (non-linear) payoffs, systematic volatility prices sufficiently in-the-money (out-of-the-money) options with the opposite (same) sign as idiosyncratic volatility. Using single-stock calls as test assets, double-sorted portfolios and Fama–MacBeth (1973) regressions broadly support the model’s predictions.

Mispricing, short-sale constraints, and the cross-section of option returns

Motivated by the theory of demand-based option pricing in imperfect markets, we examine the relation between short-sale constraints and equity option returns, conditional on the level of mispricing in the underlying stock. We report a monotonic relation between various measures of short-sale constraints and delta-hedged returns of put options on overpriced stocks. This relation is robust to controls for firm attributes and limits to arbitrage proxies. Our findings suggest that while investors drive up the demand for these put options, dealers command a high premium as compensation for the increased market making risk. We do not find a robust relation for either put options on underpriced stocks or call options.

Mispricing, Short-Sale Constraints, and the Cross-Section of Option Returns

Motivated by the theory of demand-based option pricing in imperfect markets, we examine the relation between short-sale constraints and equity option returns, conditional on the level of mis-pricing in the underlying stock. We report a monotonic relation between various measures of short-sales constraints and delta-hedged returns of put options on overpriced stocks. This relation is robust to controls for firm attributes and limits to arbitrage proxies. Our findings suggest that while investors drive up the demand for these put options, dealers command a high premium as compensation for the increased market making risk. We do not find a robust relation for either put options on under-priced stocks or call options.

Media Sentiment and the Cross-Section of Option Returns

Media Sentiment and the Cross-Section of Option Returns

Stock Return Autocorrelations and the Cross Section of Option Returns

We present a new finding that the return autocorrelation of underlying stock is an important determinant of expected equity option returns. Using an extended Black-Scholes model incorporating the presence of stock return autocorrelation, we show that expected returns of both call and put options are increasing in return autocorrelation coefficient of the underlying stock. Consistent with this insight, we find strong empirical support in the cross-section of average returns of equity options. Average returns of calls and puts as well as average returns of straddles all show monotonically increasing relationship with the degree of underlying stock's return autocorrelation coefficient. Additional equity option portfolio analysis shows that the information on stock return autocorrelation helps investors to significantly improve the out-of-sample performance of their portfolios.

Volatility-of-volatility and the cross-section of option returns

This paper presents a robust new finding of a significant negative relation between equity option returns and the volatility-of-volatility (VOV). After controlling for numerous existing option and stock characteristics, the VOV effect remains significantly negative. It also survives many robustness checks. A conceptual model provided reveals the pricing mechanism behind the VOV effect. The high-low return spread on option portfolios sorted on VOV cannot be explained by standard risk factors, and survives double sorting using a variety of control variables.

Consumption Risk and the Cross-Section of Option Returns

We offer evidence that exposures to consumption growth, expected consumption growth, and consumption volatility are significantly priced in the cross-section of delta-hedged option and straddle returns. Consumption growth and expected consumption growth command a positive risk premium, whereas consumption volatility commands a negative risk premium. In a representative-agent economy with recursive preferences, our results suggest that investors prefer early resolution of uncertainty. Our results further suggest that consumption risk exposures provide rational foundations for well-known relations between option moneyness or idiosyncratic underlying-stock volatility and the cross-section of delta-hedged option or straddle returns.

Volatility Uncertainty and the Cross-Section of Option Returns

This paper studies the relation between the uncertainty of volatility, measured as the volatility of volatility, and future delta-hedged equity option returns. We find that delta-hedged option returns consistently decrease in uncertainty of volatility. Our results hold for different measures of volatility such as implied volatility, EGARCH volatility from daily returns, and realized volatility from high-frequency data. The results are robust to firm characteristics, stock and option liquidity, volatility characteristics, and jump risks, and are not explained by common risk factors. Our findings suggest that option dealers charge a higher premium for single-name options with high uncertainty of volatility, because these stock options are more difficult to hedge.

Equity Volatility Term Structures and the Cross Section of Option Returns

The slope of the implied volatility term structure is positively related to future option returns. I rank firms based on the slope of the volatility term structure and analyze the returns for straddle portfolios. Straddle portfolios with high slopes of the volatility term structure outperform straddle portfolios with low slopes by an economically and statistically significant amount. The results are robust to different empirical setups and are not explained by traditional factors, higher-order option factors, or jump risk.

Macroeconomic uncertainty and the cross-section of option returns

I empirically investigate whether macroeconomic uncertainty is a priced risk factor in the cross-section of equity and index option returns. The analysis employs a non-linear factor model, estimated with the Fama-MacBeth methodology, where the macroeconomic uncertainty factor is the return on a long/short portfolio of equity options, built on the basis of how implied volatilities change around macroeconomic announcements. I find that macroeconomic uncertainty is priced in the cross-section of option returns, even after controlling for a number of relevant factors. The results are robust to alternative ways of measuring option returns, and to the non-random pattern of missing returns.

Free (Almost) Variance Insurance

The expected returns of short maturity options are large and negative, implying a negative variance risk premium. We find that the magnitude of this negative risk premium is monotonically decreasing with option maturity. The risk premium becomes insignificant for maturities beyond 6 months and the cost to insure the variance risk using long maturity options is 6 bps per month. In the context of a classical asset pricing model, this pattern suggests that variance betas should also be declining with maturity because the risk premium is proportional to the factor loading. However, variance betas are increasing with option maturity, challenging a one-factor model of the variance risk. A one-factor model of the short-term variance risk (level) fails to explain the cross-section of option returns and is forcefully rejected by asset pricing tests. We identify a slope factor in the term structure of risk neutral variances and find it crucial in explaining the cross section of option returns. The slope and level factors combined explain over 90% of the option return variations.

Macroeconomic Uncertainty and the Cross-Section of Option Returns

I empirically investigate whether macroeconomic uncertainty is a priced risk factor in the cross-section of equity and index option returns. The analysis employs a non-linear factor model, estimated with the Fama-MacBeth methodology, where the macroeconomic uncertainty factor is the return on a long/short portfolio of equity options, built on the basis of how implied volatilities change around scheduled macroeconomic announcements. I find that macroeconomic uncertainty is priced in the cross-section of option returns, even after controlling for a large set of relevant factors. The results are also robust to alternative ways of measuring option returns, and to the non-random pattern of missing returns.

Volatility Term Structure and the Cross-Section of Option Returns

The slope of the implied volatility term structure is positively related to future option returns. We rank firms based on the slope of the volatility term structure and analyze the returns for straddle portfolios. Straddle portfolios with high slopes of the volatility term structure outperform straddle portfolios with low slopes by an economically and statistically significant amount. The results are robust to different empirical setups and are not explained by traditional factors, higher-order option factors, or jump risk.

Cashing in on Fear: Implied Jump Risk Premium and the Cross-Section of Option Returns

This paper examines the relationship between asset jump risk premium and the cross section of option returns. Empirically, we estimate jump risk premium from two different measures of the slope of the implied volatility smile. Our results show that options written on the stocks with high jump risk premium outperform options written on stocks with the low jump risk premiums.

Volatility Term Structure and the Cross-Section of Option Returns

Volatility Term Structure and the Cross-Section of Option Returns

Volatility Mean Reversion and the Cross-Section of Option Returns

Volatility Mean Reversion and the Cross-Section of Option Returns