48 Pages Posted: 17 Mar 2011 Last revised: 27 Nov 2016
Date Written: July 3, 2012
This paper documents a robust new finding that delta-hedged equity option return decreases monotonically with an increase in the idiosyncratic volatility of the underlying stock. This result can not be explained by standard risk factors. It is distinct from existing anomalies in the stock market or volatility-related option mispricing. It is consistent with market imperfections and constrained financial intermediaries. Dealers charge a higher premium for options on high idiosyncratic volatility stocks due to their higher arbitrage costs. Controlling for limits to arbitrage proxies reduces the strength of the negative relation between delta-hedged option return and idiosyncratic volatility by about 40%.
Keywords: Option return; Idiosyncratic volatility; Market imperfections; Limits to arbitrage
JEL Classification: G02; G12; G13
Suggested Citation: Suggested Citation
Cao, Jie and Han, Bing, Cross-Section of Option Returns and Idiosyncratic Stock Volatility (July 3, 2012). AFA 2012 Chicago Meetings Paper; Journal of Financial Economics (JFE), Vol. 108, No. 1, 2013; McCombs Research Paper Series No. FIN-15-09. Available at SSRN: https://ssrn.com/abstract=1786607