The World Price of Jump and Volatility Risk
Tilburg University - Department of Finance; CentER Tilburg University
Pascal J. Maenhout
INSEAD - Finance
AFA 2005 Philadelphia Meetings, Forthcoming
Jump and volatility risk are important for understanding equity returns, option pricing and asset allocation. This paper is the first to study international integration of markets for jump and volatility risk, using data on index options for each of the three main global markets: US S&P 500 index options), Europe (FTSE index options) and Asia (Nikkei index options). To explain the cross-section of expected returns on these options across strikes and maturities, we focus on return-based multi-factor models, using returns on straddles and out-of-the-money put options as proxies for volatility and jump risk factors. For each market separately, we provide evidence that volatility and jump risk are priced risk factors. There is little evidence, however, of global unconditional pricing of jump and volatility risk. We then investigate the presence of time-variation in the cross-market relationships and find evidence that UK and US option markets have become increasingly interrelated. Incorporating these time-varying patterns in conditional factor pricing models improves their fit substantially and generates some evidence of international pricing. Finally, we show that the benefits of diversifying jump and volatility risk internationally are substantial, but declining over our sample, in line with the hypothesis of increased but imperfect integration of world markets for jump and volatility risk.
Number of Pages in PDF File: 53
Date posted: January 2, 2005