Transition Risk Premiums in Option Prices

Abstract

The economy is in a transition process to a low-carbon state, inducing an additional source of risk for stocks, the transition risk. Using a measure of transition risk at individual firm level, the carbon beta developed by Goergen et al. (2020), we analyze various option measures to examine the relationship between a firm's transition risk and option hedging costs. In contrast to the previous literature, we find evidence that only the absolute value of a firm's exposure to the transition process, and not its sign, is relevant for the expensiveness of options. In particular, options on firms with a high absolute value of the carbon beta are charged with a higher volatility risk premium, whereas anticipated downside tail risks are larger for green firms. The pricing of transition-related volatility risk is increasing over time and appears to be a fairly new phenomenon.

Keywords: Transition risk, Carbon risk, Option pricing, Volatility risk, Jump risk, Delta-hedged option returns

JEL Classification: G12, G13, Q54