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Cross-Section of Option Returns and Idiosyncratic Stock VolatilityJie CaoChinese University of Hong Kong Bing HanUniversity of Texas at Austin - McCombs School of Business July 3, 2012 McCombs Research Paper Series No. FIN-15-09 AFA 2012 Chicago Meetings Paper Abstract: This paper documents a robust new finding that delta-hedged equity option return decreases monotonically with an increase in the idiosyncratic volatility of the underlying stock. This result can not be explained by standard risk factors. It is distinct from existing anomalies in the stock market or volatility-related option mispricing. It is consistent with market imperfections and constrained financial intermediaries. Dealers charge a higher premium for options on high idiosyncratic volatility stocks due to their higher arbitrage costs. Controlling for limits to arbitrage proxies reduces the strength of the negative relation between delta-hedged option return and idiosyncratic volatility by about 40%.
Number of Pages in PDF File: 48 JEL Classification: G12, G13 Accepted Paper SeriesDate posted: March 17, 2011 ; Last revised: November 25, 2012Suggested CitationContact Information
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