Mutual Fund Hedging Demands and the Cross-Section of Variance Risk Premiums

63 Pages Posted: 10 Nov 2020 Last revised: 26 Dec 2020

See all articles by Shuaiqi Li

Shuaiqi Li

University of Maryland, R.H Smith School of Business

Date Written: November 8, 2020

Abstract

This paper examines the pricing implication of mutual fund activities in equity option markets. I present a robust new finding that the mutual fund ownership concentration of a firm's stocks, measured as the Herfindahl-Hirschman Index (HHI), negatively predicts the cross-sectional variance risk premiums (VRP). HHI can be interpreted as a proxy for mutual fund hedging demand against stochastic volatility risks originated from their stock positions. An increase in mutual fund ownership concentration in the underlying stock drives up the hedging demand for equity options. To absorb the increased order imbalances, dealers charge a higher premium, leading to a more negative VRP. Using actual option holdings of U.S. equity funds, I find a positive relation between the firm's HHI and the same firm's option market share held by mutual funds. After decomposing firm VRP into systematic and idiosyncratic components, I find that HHI is negatively related with both components.

Keywords: variance risk premium; mutual fund; demand-based and cross-sectional option pricing.

JEL Classification: G13; G14; G23

Suggested Citation

Li, Shuaiqi, Mutual Fund Hedging Demands and the Cross-Section of Variance Risk Premiums (November 8, 2020). Available at SSRN: https://ssrn.com/abstract=3726935 or http://dx.doi.org/10.2139/ssrn.3726935

Shuaiqi Li (Contact Author)

University of Maryland, R.H Smith School of Business ( email )

7621 Mowatt Ln
College Park, MD 20742

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