The Puzzle of Index Option Returns
42 Pages Posted: 21 Oct 2009 Last revised: 25 Sep 2012
Date Written: February 9, 2012
We document that leverage-adjusted returns on S&P 500 index call and put portfolios are decreasing in their strike-to-price ratio over 1986-2010, contrary to the prediction of the Black-Scholes-Merton model. We test a large number of plausible unconditional factor models and find that only factors which capture jumps in the market index and jumps in the market volatility and, to a lesser extent, volatility and liquidity reasonably explain the cross-section of index options. The principal finding is that these factors require economically and statistically different factor premia on subsamples split across type (calls and puts), maturity, and moneyness, pointing towards market segmentation.
Keywords: index option returns, option mispricing, volatility jumps, price jumps, liquidity, market efficiency
JEL Classification: G11, G13, G14
Suggested Citation: Suggested Citation