Demand in the Option Market and the Pricing Kernel
64 Pages Posted: 30 Dec 2022
Date Written: December 28, 2022
We show that net demand in the S&P 500 option market is fundamental to explain empirical puzzles related to the pricing kernel. When public investors (non-market makers) are exposed to variance risk by net-selling out-of-the-money (OTM) options, the pricing kernel is U-shaped, expected option returns are low and the variance risk premium is high. Conversely, when public investors are protected against variance risk by net-buying OTM options, the pricing kernel is decreasing in market returns, expected option returns are high and the variance risk premium is low. Our findings support equilibrium models with heterogeneous agents in which options are nonredundant.
Keywords: Pricing Kernel, Option Returns, Option Demand, Market Makers, Risk Premium
JEL Classification: G11, G12, G13
Suggested Citation: Suggested Citation