Risk Premia and Option Intermediation

67 Pages Posted: 12 Apr 2023

See all articles by Thomas Gruenthaler

Thomas Gruenthaler

University of Muenster - Finance Center Muenster

Date Written: December 4, 2022

Abstract

Equity index risk premia vary more than can be explained by market risks and pricing models. I show that index option intermediaries cause variation in risk premia to manage their option positions. When expected volatility is low, intermediaries hold risky short positions. Increasing risk and liquidity premia compensate intermediaries for the risk exposure and lower subsequent demand. When expected volatility is high, intermediaries transfer risky short positions to investors. Intermediaries induce sell orders by quoting relatively higher sell prices and charging wider effective spreads for buyer-initiated trades. As a result, intermediaries' positions are often riskless when high volatility realizes. Tighter constraints in the financial sector transmit to option intermediaries and create a reluctance to hold positions. The reluctance drives level and variation in crash risk premia independent of market risks. My results suggest that financial institutions' risk tolerance integrates option markets with other markets.

Keywords: Risk Premia, Intermediary Asset Pricing, Option Returns, Option Pricing, Crash Risk

JEL Classification: G12, G13

Suggested Citation

Gruenthaler, Thomas, Risk Premia and Option Intermediation (December 4, 2022). Available at SSRN: https://ssrn.com/abstract=4404111 or http://dx.doi.org/10.2139/ssrn.4404111

Thomas Gruenthaler (Contact Author)

University of Muenster - Finance Center Muenster ( email )

Universit├Ątsstra├če 14-16
Muenster, D-48143
Germany

HOME PAGE: http://sites.google.com/view/tgruenthaler/

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