Why Does Volatility Uncertainty Predict Equity Option Returns?
58 Pages Posted: 25 May 2018 Last revised: 28 Aug 2022
Date Written: August 26, 2022
Delta-hedged option returns consistently decrease in volatility of volatility changes (volatility uncertainty), for both implied and realized volatilities. We provide a thorough investigation of the underlying mechanisms including model-risk and gambling-preference channels. Uncertainty of both volatilities amplifies the model risk, leading to a higher option premium charged by dealers. Volatility of volatility-increases, rather than that of volatility-decreases, contributes to the effect of implied volatility uncertainty, supporting the gambling-preference channel. We further strengthen this channel by examining the effects of option end-users net demand and lottery-like features, and by decomposing implied volatility changes into systematic and idiosyncratic components.
Keywords: Delta-hedged option returns, volatility uncertainty, volatility-of-volatility, model risk, gambling preference
JEL Classification: G10, G12, C58, D80
Suggested Citation: Suggested Citation