An Empirical Investigation of UK Option Returns: Overpricing and the Role of Higher Systematic Moments

31 Pages Posted: 9 Nov 2004

See all articles by Fergal O'Brien

Fergal O'Brien

University of Limerick - Kemmy Business School

Mark B. Shackleton

Lancaster University - Department of Accounting and Finance

Abstract

The Capital Asset Pricing Model (CAPM) assumes either that all asset returns are normally distributed or that investors have mean-variance preferences. Given empirical observations of asset returns, which document evidence of skewness and kurtosis, both assumptions are suspect. While several studies have investigated incorporating higher moments into asset pricing models using equity data, literature on the contribution of the third and fourth moments in explaining the return-generating process in options markets is sparse. Using a two-pass methodology we investigate an asset pricing model that allows moments of higher order than two using European style exercise (ESX) equity index option data from the London International Financial Futures and Options Exchange (LIFFE). Our empirical investigation shows that ESX option contracts appear to be overpriced and that on average almost all puts and calls earn negative daily returns during our ten-year sample period. Furthermore, our regression results show that systematic variance has a significant role in explaining the cross-section of option returns and that the role of systematic skewness and systematic kurtosis throughout the sample period is less clear.

Keywords: Option returns, CAPM, systematic, skewness, kurtosis, comoments, cross-section

Suggested Citation

O'Brien, Fergal and Shackleton, Mark B., An Empirical Investigation of UK Option Returns: Overpricing and the Role of Higher Systematic Moments. Available at SSRN: https://ssrn.com/abstract=615743 or http://dx.doi.org/10.2139/ssrn.615743

Fergal O'Brien

University of Limerick - Kemmy Business School ( email )

Limerick
Ireland

Mark B. Shackleton (Contact Author)

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom
44 1524 594131 (Phone)
44 1524 847321 (Fax)