Systematic Variance Risk and Firm Characteristics in the Equity Options Market

52 Pages Posted: 10 Oct 2007

Date Written: December 2006


We construct synthetic variance swap returns from prices of traded options to investigate the pricing of systematic variance risk in the equity options market. Cross sectional tests reveal no evidence of a negative market variance risk premium. Furthermore, we show that a class of linear factor models cannot simultaneously explain index and equity option prices. In particular, equity options appear to be underpriced relative to index options. To exploit the mispricing, we analyze an investment strategy known as dispersion trading, which is implemented by going long a portfolio of equity options, and short a portfolio of index options. After transaction costs, the strategy generates a Sharpe ratio which is more than four times greater than that of the market.

We also find that equity option prices are related to underlying firm characteristics: Options on small and value stocks are more expensive than options on large and growth stocks, respectively. We find that these results are not explained by di.erential exposure to risk factors, nor by market microstructure considerations. One interpretation is that investors overestimate risk on small and value stocks. This finding provides a new context for understanding the size and value anomalies in stock returns: It suggests that investors expect higher rates of return on small and value stocks because they perceive them to be riskier than they truly are.

Keywords: Equity Options, Model Free Implied Volatility, Variance Risk, Size Effect, Book-to-Market Effect

JEL Classification: G10, G12, G13

Suggested Citation

di Pietro, Vadim and Vainberg, Gregory, Systematic Variance Risk and Firm Characteristics in the Equity Options Market (December 2006). Available at SSRN: or

Vadim Di Pietro (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Gregory Vainberg

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1

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