Margin Requirements and Equity Option Returns

Abstract

In equity option markets, traders face margin requirements on their portfolios of options and underlying stocks. We show that individual equity option returns carry a margin premium, which is determined by an option's contribution to dealers' overall margin requirements. The margin premium is a statistically and economically significant component of the cross-section of option returns, and robust in various subsamples and after controlling for established drivers of option returns. Our empirical analysis is guided by a model of funding-constrained derivatives dealers who require compensation for satisfying end-users' demand.

Keywords: equity options, margin requirements, financial intermediaries, funding liquidity, cross-section of option returns

JEL Classification: G12, G13