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

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