Dark Matter in (Volatility and) Equity Option Risk Premiums

43 Pages Posted: 23 Nov 2019 Last revised: 9 Mar 2021

See all articles by Gurdip Bakshi

Gurdip Bakshi

Temple University - Fox School of Business and Management; 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 the equity price index, its volatility, and the pricing kernel were to be absent of unspanned risks, it would counterfactually imply that (i) the expected excess return of out-of-the-money calls on equity is positive and (ii) the expected excess return of straddles is zero. Remedying these contradictions, we equip the pricing kernel process with unspanned risks, embed (unspanned) jump risks, and allow return volatility to contain unspanned risks. The empirical evidence from weekly and farther-dated 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, semi-martingales, dark matter, option risk premiums

Suggested Citation

Bakshi, Gurdip S. and Crosby, John and Gao, Xiaohui, Dark Matter in (Volatility and) Equity Option Risk Premiums (November 12, 2019). Fox School of Business Research Paper Forthcoming, Available at SSRN: https://ssrn.com/abstract=3485672 or http://dx.doi.org/10.2139/ssrn.3485672

Gurdip S. Bakshi

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

Philadelphia, PA 19122
United States

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

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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