Dark Matter in (Volatility and) Equity Option Risk Premiums

Operations Research, forthcoming

55 Pages Posted: 23 Nov 2019 Last revised: 15 Jun 2022

See all articles by Gurdip Bakshi

Gurdip Bakshi

Fox School of Business; Temple University - Fox School of Business and Management

John Crosby

University of Maryland - Robert H. Smith School of Business

Xiaohui Gao

Fox School of Business, Temple University

Date Written: November 12, 2019

Abstract

Emphasizing the statistics of jumps crossing the strike and local time, we develop a decomposition
of equity option risk premiums. Operationalizing this theoretical treatment, we equip the pricing kernel process with unspanned risks, embed (unspanned) jump risks, and allow equity return volatility to contain unspanned risks. Unspanned risks are consistent with negative risk premiums for jumps crossing the strike and local time and imply negative risk premiums for out-of-the-money call options and straddles. The empirical evidence from weekly and fartherdated index options is supportive of our theory of economically relevant unspanned risks and reveals “dark matter” in option risk premiums.

Keywords: Unspanned equity volatility and jump risks, unspanned risks in the pricing kernel, dark matter, option risk premiums

Suggested Citation

Bakshi, Gurdip S. and Bakshi, Gurdip S. and Crosby, John and Gao, Xiaohui, Dark Matter in (Volatility and) Equity Option Risk Premiums (November 12, 2019). Operations Research, forthcoming, 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

Temple University - Fox School of Business and Management ( email )

Philadelphia, PA 19122
United States

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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