The Dark Matter in Equity Index Volatility Dynamics: Assessing the Economic Rationales for Unspanned Risks

34 Pages Posted: 23 Nov 2019

See all articles by Gurdip Bakshi

Gurdip Bakshi

Fox School of Business

John Crosby

University of Maryland - Robert H. Smith School of Business

Xiaohui Gao Bakshi

Fox School of Business, Temple University

Date Written: November 12, 2019

Abstract

If the evolution of equity index volatility and the pricing kernel were to be absent of risks unspanned by index futures, it would counterfactually imply that (i) the expected excess return of OTM calls on futures is positive, (ii) the expected excess return of straddles is approximately zero, and (iii) futures returns and changes in volatility are perfectly correlated. Remedying these contradictions, we consider a specification of market incompleteness that equips the pricing kernel and volatility dynamics with unspanned risks and generates negative local time risk premiums. The empirical evidence is supportive of our theory of economically relevant unspanned risks.

Keywords: Unspanned equity volatility risks, unspanned risks in the pricing kernel, expected excess return of options on equity index futures.

Suggested Citation

Bakshi, Gurdip S. and Crosby, John and Gao, Xiaohui, The Dark Matter in Equity Index Volatility Dynamics: Assessing the Economic Rationales for Unspanned Risks (November 12, 2019). Available at SSRN: https://ssrn.com/abstract=3485672 or http://dx.doi.org/10.2139/ssrn.3485672

Gurdip S. Bakshi

Fox School of Business ( email )

Department of Finance
Philadelphia, PA 19022
United States
215-204-6117 (Phone)
tuk40718@temple.edu (Fax)

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

John Crosby

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
+447979901892 (Phone)

HOME PAGE: http://www.john-crosby.co.uk/

Xiaohui Gao (Contact Author)

Fox School of Business, Temple University ( email )

Philadelphia, PA 19122
United States

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