The Price of Market Volatility Risk

59 Pages Posted: 18 Mar 2008  

Jefferson Duarte

Rice University

Christopher S. Jones

University of Southern California - Marshall School of Business - Finance and Business Economics Department

Date Written: October 28, 2007

Abstract

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

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

Jefferson Duarte

Rice University ( email )

6100 South Main Street
P.O. Box 1892
Houston, TX 77005-1892
United States
713.3486137 (Phone)

Christopher S. Jones (Contact Author)

University of Southern California - Marshall School of Business - Finance and Business Economics Department ( email )

Marshall School of Business
Los Angeles, CA 90089
United States

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