The Pricing of Volatility and Jump Risks in the Cross-Section of Index Option Returns

60 Pages Posted: 28 Sep 2019

See all articles by Guanglian Hu

Guanglian Hu

The University of Sydney - Discipline of Finance

Yuguo Liu

University of Houston - C.T. Bauer College of Business

Date Written: September 16, 2019

Abstract

In the data, out-of-the-money (OTM) S&P 500 call and put options both have puzzling low average returns. Existing studies relate these results to models with non-standard preferences. We argue that the low returns on OTM index options are primarily due to the pricing of market volatility risk. When volatility risk is priced, expected option returns match the average returns of call and put options across all strikes as well as returns of option portfolios. Consistent with the differential impact of the volatility risk premium on expected option returns, we also find that the market volatility risk premium is positively related to future index option returns and this relationship is stronger for OTM options and ATM straddles. Lastly, we find some portion of OTM put option returns are attributable to the jump risk premium.

Keywords: volatility risk premium; jump risk premium; expected option returns; the cross-section of index option returns

JEL Classification: G12 G13

Suggested Citation

Hu, Guanglian and Liu, Yuguo, The Pricing of Volatility and Jump Risks in the Cross-Section of Index Option Returns (September 16, 2019). Available at SSRN: https://ssrn.com/abstract=3455794 or http://dx.doi.org/10.2139/ssrn.3455794

Guanglian Hu (Contact Author)

The University of Sydney - Discipline of Finance ( email )

Room 543 H69 Codrington Building
University of Sydney
Sydney, NSW 2006
Australia

Yuguo Liu

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

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