51 Pages Posted: 28 Feb 2007
Date Written: May 3, 2007
This paper studies the returns from investing in index options. Previous research documents significant average option returns, large CAPM alphas, and high Sharpe ratios, and concludes that put options are mispriced. We propose an alternative approach to evaluate the significance of option returns and obtain different conclusions. Instead of using these statistical metrics, we compare historical option returns to those generated by commonly used option pricing models. We find that the most puzzling finding in the existing literature, the large returns to writing out-of-the-money puts, is not even inconsistent with the Black-Scholes model. Moreover, simple stochastic volatility models with no risk premia generate put returns across all strikes that are not inconsistent with the observed data. At-the-money straddle returns are more challenging to understand, and we find that these returns are not inconsistent with explanations such as jump risk premia, Peso problems, and estimation risk.
Keywords: put pricing puzzle, option returns, jump-diffusion models, risk premia
JEL Classification: G12, G13, C13, C22
Suggested Citation: Suggested Citation
Broadie, Mark and Johannes, Michael S. and Chernov, Mikhail, Understanding Index Option Returns (May 3, 2007). AFA 2008 New Orleans Meetings Paper. Available at SSRN: https://ssrn.com/abstract=965739 or http://dx.doi.org/10.2139/ssrn.965739