Options and Risk

55 Pages Posted: 22 Jul 2020

See all articles by Giovanni Bruno

Giovanni Bruno

EDHEC Business School - Scientific Beta

Jørgen Haug

Norwegian School of Economics (NHH) - Department of Finance

Date Written: June 22, 2020

Abstract

We propose a parsimonious general equilibrium extension of the Black-Scholes economy that helps clarify how options' prices, expected returns, risk exposure, and optimal exercise policies respond to variations in the risk exposure of the underlying asset. The model allows one to separate the effects from changes in idiosyncratic versus systematic risk. Among the new insights we establish are that i) call prices typically respond negatively to increases in systematic risk, ii) the magnitude of call and put options' expected returns are monotonically decreasing in idiosyncratic risk, and iii) the optimal exercise date of an American put can be pushed backwards in time in response to an increase in systematic risk---decreasing the value of waiting. The effects of a change in risk on options are generally ambiguous because it affects their prices through two key channels---the volatility channel and the price channel---and a change in systematic risk causes a repricing of the underlying asset that may dominate the volatility channel. The comparative statics are robust to the presence of stochastic volatility, and thus yield internally consistent implications not only for the cross-section of options but also for the time-series of a particular option.

Keywords: Option pricing, general equilibrium, idiosyncratic risk, systematic risk

JEL Classification: G12, G13, G31

Suggested Citation

Bruno, Giovanni and Haug, Jørgen, Options and Risk (June 22, 2020). Available at SSRN: https://ssrn.com/abstract=3633825 or http://dx.doi.org/10.2139/ssrn.3633825

Giovanni Bruno

EDHEC Business School - Scientific Beta ( email )

393 Prom. des Anglais
Nice, PACA 06200
France

Jørgen Haug (Contact Author)

Norwegian School of Economics (NHH) - Department of Finance ( email )

Helleveien 30
N-5045 Bergen
Norway

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