Variance Risk, Financial Intermediation, and the Cross-Section of Expected Option Returns

73 Pages Posted: 14 Mar 2011

See all articles by Norman Schürhoff

Norman Schürhoff

University of Lausanne; Swiss Finance Institute; Centre for Economic Policy Research (CEPR)

Alexandre Ziegler

University of Zurich - Department of Banking and Finance

Date Written: February 2011

Abstract

We explore the pricing of variance risk by decomposing stocks' total variance into systematic and idiosyncratic return variances. While systematic variance risk exhibits a negative price of risk, common shocks to the variances of idiosyncratic returns carry a large positive risk premium. This implies investors pay for insurance against increases (declines) in systematic (idiosyncratic) variance, even though both variances comove countercyclically. Common idiosyncratic variance risk is an important determinant for the cross-section of expected option returns. These findings reconcile several phenomena, including the pricing differences between index and stock options, the cross-sectional variation in stock option expensiveness, the volatility mispricing puzzle, and the significant returns earned on various option portfolio strategies. Our results are consistent with theories of financial intermediation under capital constraints.

Keywords: asset pricing, cross-section of option returns, financial intermediation, variance risk

JEL Classification: G12, G13, G24

Suggested Citation

Schürhoff, Norman and Ziegler, Alexandre, Variance Risk, Financial Intermediation, and the Cross-Section of Expected Option Returns (February 2011). CEPR Discussion Paper No. DP8268. Available at SSRN: https://ssrn.com/abstract=1782562

Norman Schürhoff (Contact Author)

University of Lausanne ( email )

Extranef 228
CH-1015 Lausanne
Switzerland
+41 (0)21 692 3447 (Phone)
+41 (0)21 692 3435 (Fax)

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Alexandre Ziegler

University of Zurich - Department of Banking and Finance ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland

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