Volatility and Expected Option Returns: A Note

19 Pages Posted: 3 Sep 2016 Last revised: 21 Jan 2017

See all articles by Mo Chaudhury

Mo Chaudhury

McGill University - Desautels Faculty of Management

Date Written: August 30, 2016

Abstract

Are options on more volatile assets expected to provide higher or lower return? Using analytics, we show the ambiguous nature of the answer when the volatility differential is due to the systematic/priced risk. Here the difference in the expected return of the assets also matters and has an effect on expected option return that is opposite to the case of idiosyncratic/unpriced risk. Our numerical results, based on more than 13 million parameter combinations, elaborate how the direction and magnitude of the net effect depends on the levels of asset beta and volatility and the moneyness and maturity of options. Accordingly, in analyzing the cross-section of returns on traded options, securities with embedded options, and other nonlinear derivatives, one should pay attention to the source of volatility differential, and the sample range/mix of betas, volatilities, and option moneyness and maturity.

Keywords: Volatility, Expected Option Return, Cross-Section of Option Returns

JEL Classification: G12, G13

Suggested Citation

Chaudhury, Mo, Volatility and Expected Option Returns: A Note (August 30, 2016). Economics Letters, Vol. 152, No. March, 2017, Available at SSRN: https://ssrn.com/abstract=2833943 or http://dx.doi.org/10.2139/ssrn.2833943

Mo Chaudhury (Contact Author)

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A 1G5
Canada
(514) 398-5927 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://www.mcgill.ca/desautels/mo-chaudhury

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