On the negative market volatility risk-premium: Bridging the gap between option returns and the pricing of options

Alfredo Ibáñez Rodríguez

Research output: Working paper

Abstract

Existing evidence indicates that (i) average returns of purchased delta-hedged options are negative, implying options are expensive, and (ii) volatility is the most important extra risk that is factored into option prices. Therefore, a natural extension is to explain the cross-section of average delta-hedged option returns in a stochastic volatility model. This paper solves this problem by introducing a measure of option overprice, which quantifies the impact on option prices of the volatility risk premium. It is an application of option-pricing in incomplete markets under stochastic volatility. An extensive numerical exercise shows the option overprice is consistent with the cross-section of average delta-hedged returns of calls, puts, and straddles reported by the literature for the S&P 500 index, except for expensive short-term out-of-the-money puts. In a stochastic volatility model, the volatility risk of at- and, especially, out-of-the-money calls and puts is several times larger than market volatility, which explains large negative volatility risk premiums if volatility risk is negative priced.
Original languageEnglish
Number of pages38
Publication statusPublished - 1 Jun 2007
Externally publishedYes

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