Demand in the Option Market and the Pricing Kernel

64 Pages Posted: 30 Dec 2022

See all articles by Caio Almeida

Caio Almeida

Princeton University

Gustavo Freire

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Tinbergen Institute; Erasmus Research Institute of Management (ERIM)

Date Written: December 28, 2022

Abstract

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

Almeida, Caio and Freire, Gustavo, Demand in the Option Market and the Pricing Kernel (December 28, 2022). Proceedings of the EUROFIDAI-ESSEC Paris December Finance Meeting 2023, Available at SSRN: https://ssrn.com/abstract=4314173 or http://dx.doi.org/10.2139/ssrn.4314173

Caio Almeida (Contact Author)

Princeton University ( email )

26 Prospect Avenue
Princeton, NJ 08540
United States

Gustavo Freire

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

HOME PAGE: http://https://www.eur.nl/people/gustavo-freire

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

HOME PAGE: http://https://tinbergen.nl/person/2029/gustavo-freire

Erasmus Research Institute of Management (ERIM) ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands

HOME PAGE: http://https://www.erim.eur.nl/people/gustavo-freire/

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