59 Pages Posted: 18 Mar 2008
Date Written: October 28, 2007
We analyze the volatility risk premium by applying a modified two-pass Fama-MacBeth procedure to the returns of a large cross section of the returns of options on individual equities. Our results provide strong evidence of a volatility risk premium that is increasing in the level of overall market volatility. This risk premium provides compensation for risk stemming both from the characteristics of the option contract and the riskiness of the underlying equity. We also show with a large scale Monte Carlo simulation that measurement error in option prices and violations of arbitrage bounds induce highly economically significant biases in the mean returns of options. In fact, our simulation results demonstrate that biases can be up to several percentage points per day. These large biases can lead researchers to faulty conclusions with respect to both the magnitude of the volatility risk premium and the sign of expected option returns.
Keywords: volatility, options
JEL Classification: G12,G13
Suggested Citation: Suggested Citation
Duarte, Jefferson and Jones, Christopher S., The Price of Market Volatility Risk (October 28, 2007). AFA 2009 San Francisco Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1106960 or http://dx.doi.org/10.2139/ssrn.1106960
By David Bates