The Pricing of Market and Idiosyncratic Jump and Volatility Risks

64 Pages Posted: 24 May 2019 Last revised: 3 Jul 2019

See all articles by T. Frederik Middelhoff

T. Frederik Middelhoff

University of Muenster - Finance Center Muenster

Date Written: April 29, 2019

Abstract

This paper analyzes the risk-return relation of different variance components in the cross-section of option and stock returns. Using option portfolios that have a constant exposure to either jump or diffusive risk, I decompose variance risk into four components: market volatility risk, idiosyncratic volatility risk, market jump risk, and idiosyncratic jump risk. The lion’s share of stocks' variance risk is paid for the idiosyncratic components, with Sharpe Ratios of -3.44 for idiosyncratic jump risk and 2.15 for idiosyncratic volatility risk. While all four components are at play when stocks earn negative returns, idiosyncratic jump and volatility risks are most important to explain positive returns. In addition, stocks that have higher idiosyncratic jump risk premiums earn higher future returns.

Keywords: Options, Stock Returns, Idiosyncratic Risk, Volatility Risk, Jump Risk

JEL Classification: G12, G13

Suggested Citation

Middelhoff, Frederik T., The Pricing of Market and Idiosyncratic Jump and Volatility Risks (April 29, 2019). Available at SSRN: https://ssrn.com/abstract=3379541 or http://dx.doi.org/10.2139/ssrn.3379541

Frederik T. Middelhoff (Contact Author)

University of Muenster - Finance Center Muenster ( email )

Schlossplatz 2
Muenster
Germany

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