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Pieces of the index option return puzzle: Some new evidence
Rainer Baule, Florian Borchard
FernUniversität in Hagen, Germany
Discussant: Fanchen Meng (Karlsruhe Institut für Technologie)
Returns of OTM-index-options are negative on average and do not match expectations when only the observed equity risk premium is considered. Some studies argue that either jump or volatility risk premiums provide a sufficient explanation for the puzzle. We investigate replicability of earlier conflicting results and cover new aspects, including the impact of volatility, an alternative model for jumps, and the term structure of returns, based on weekly options.
Model predictions for the impact of volatility match evidence for equity options and alternative jumps do not enhance the explanation. With constant relative risk aversion adopted from previous literature, newer data and weekly options enable rejection of both jump risk and volatility risk premiums for the cross section of returns.
2:30pm - 3:00pm
Long-run and short-run idiosyncratic stock volatilities and cross-section of option returns
Quan Gan, Van Quoc Thinh Nguyen
University of Sydney, Australia
Discussant: Florian Borchard (FernUniversität in Hagen)
We decompose stock idiosyncratic volatility into long-run and short-run components and find that both are negatively related to delta-hedged option returns. The effects of the long-run and short-run components are explained by the limits-of-arbitrage and stock return jumps, respectively. Unlike the long-run component, the short-run component can be used to create a trading strategy that remains profitable after considering transaction costs. In downturns, only the short-run idiosyncratic volatility effect is significant. Further analysis shows that the limits-of-arbitrage’s explaining power arises from its intercept and common component, while jump’s explaining power arises from its residual component relating to corporate news arrivals.
3:00pm - 3:30pm
How option traders take sides on return predictability
Discussant: Van Quoc Thinh Nguyen (University of Sydney)
We investigate how option traders take sides on the predictability of the underlying stocks, using a wide array of cross-sectional return predictors. To infer the aggregate trading direction of option end users, we look at cross-sectional differences in the prices of option portfolios replicating the stock positions, relative to the prices of the underlying stocks themselves. We find that option traders take a profitable side on signals associated with momentum, profitability, and volatility. In contrast, they take a non-profitable side on signals that are associated with investment, and valuation.
