Expected Returns, Risk Premia, and Volatility Surfaces Implicit in Option Market Prices

16 Pages Posted: 21 Mar 2008 Last revised: 14 Nov 2010

See all articles by Antonio Camara

Antonio Camara

Oklahoma State University, Stillwater - College of Business Administration

Timothy L. Krehbiel

Oklahoma State University, Stillwater

Weiping Li

Civil Aviation Flight University of China ; Oklahoma State University

Date Written: May 16, 2008

Abstract

This article presents a pure exchange economy that extends Rubinstein (1976) to show how the jump-diffusion option pricing model of Merton (1976) is altered when jumps are correlated with diffusive risks. All correlations are statistically different from zero. In equilibrium, the equity risk premium depends not only on the risk premium factors of the traditional jump-diffusion models with systematic jump and diffusion risks, but also on both the covariance of the diffusive pricing kernel with price jumps and the covariance of the jumps of the pricing kernel with the diffusive price. These two covariances are positive, and they help to explain the sneers that we observe in the marketplace. The expected stock return is not given by the sum of the diffusive expected return and the expected return due to jumps, but it takes also into account the covariance between the diffusive return and price jumps. Our evidence is consistent with a negative covariance, which leads to a nonmonotonic term structure of implied volatilities. This leads to an asset pricing model and an option pricing model where the level of the market prices is correlated with the size of the jumps.

Keywords: Jump-diffusion, option prices, correlated jumps and diffusions, expected returns, risk premium, smile effect, term structure of implied volatilities

JEL Classification: G12, G13

Suggested Citation

Camara, Antonio and Krehbiel, Timothy L. and Li, Weiping, Expected Returns, Risk Premia, and Volatility Surfaces Implicit in Option Market Prices (May 16, 2008). Available at SSRN: https://ssrn.com/abstract=996959 or http://dx.doi.org/10.2139/ssrn.996959

Antonio Camara (Contact Author)

Oklahoma State University, Stillwater - College of Business Administration ( email )

201 Business
Stillwater, OK 74078-0555
United States

Timothy L. Krehbiel

Oklahoma State University, Stillwater ( email )

Stillwater, OK 74078-0555
United States

Weiping Li

Civil Aviation Flight University of China ( email )

46 Nanchang road
Guanghan, Sichuan 618307
China

Oklahoma State University ( email )

Stillwater, OK
United States

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