Volatility Risk Premiums Embedded in Individual Equity Options: Some New Insights
University of Massachusetts Amherst - Department of Finance
University of Maryland - Robert H. Smith School of Business
Journal of Derivatives, Fall 2003, pp. 45-54
The research indicates that index option prices incorporate a negative volatility risk premium, thus providing a possible explanation of why Black-Scholes implied volatilities of index options on average exceed realized volatilities. This examination of the empirical implication of a market volatility risk premium on 25 individual equity options provides some new insights.
While the Black-Scholes implied volatilities from individual equity options are also greater on average than historical return volatilities, the difference between them is much smaller than for the market index. Like index options, individual equity option prices embed a negative market volatility risk premium, although much smaller than for the index option - and idiosyncratic volatility does not appear to be priced.
These empirical results provide a potential explanation of why buyers of individual equity options leave less money on the table than buyers of index options.
JEL Classification: G120, G130
Date posted: September 9, 2003