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

Abstract

Existing studies relate the puzzling low average returns on out-of-the-money index call and put
options to non-standard preferences. We argue the low option returns are primarily due to the
pricing of market volatility risk. When volatility risk is priced, expected option returns match
the realized average option returns. Moreover, consistent with its theoretical effect on expected
option returns, the 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 the jump risk
premium contributes to some portion of OTM put option returns.

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

JEL Classification: G12 G13