Option-Implied Spreads and Option Risk Premia

43 Pages Posted: 21 Jun 2021 Last revised: 18 Nov 2021

See all articles by Christopher L. Culp

Christopher L. Culp

Johns Hopkins University - Institute for Applied Economics, Global Health, and Study of Business Enterprise; Swiss Finance Institute; Compass Lexecon; Financial Economics Consulting, Inc.

Mihir Gandhi

University of Chicago - Booth School of Business

Yoshio Nozawa

University of Toronto

Pietro Veronesi

University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: June 2021

Abstract

We propose implied spreads (IS) and normalized implied spreads (NIS) as simple measures to characterize option prices. IS is the credit spread of an option’s implied bond, the portfolio long a risk-free bond and short a put option. NIS normalizes IS by the risk-neutral default probability and reflects tail risk. IS and NIS are countercyclical and predict implied bond returns, while neither, like implied volatility, predicts put returns. These opposite predictability results are consistent with a stochastic volatility, stochastic jump intensity model, as put premia increase in volatility but decrease in jump intensity, while implied bond premia increase in both.

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Suggested Citation

Culp, Christopher L. and Gandhi, Mihir and Nozawa, Yoshio and Veronesi, Pietro, Option-Implied Spreads and Option Risk Premia (June 2021). Available at SSRN: https://ssrn.com/abstract=3870943 or http://dx.doi.org/10.2139/ssrn.3870943

Christopher L. Culp (Contact Author)

Johns Hopkins University - Institute for Applied Economics, Global Health, and Study of Business Enterprise ( email )

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Mihir Gandhi

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Yoshio Nozawa

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