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The risk premia embedded in index options

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  • Andersen, Torben G.
  • Fusari, Nicola
  • Todorov, Viktor

Abstract

We study the dynamic relation between market risks and risk premia using time series of index option surfaces. We find that priced left tail risk cannot be spanned by market volatility (and its components) and introduce a new tail factor. This tail factor has no incremental predictive power for future volatility and jump risks, beyond current and past volatility, but is critical in predicting future market equity and variance risk premia. Our findings suggest a wide wedge between the dynamics of market risks and their compensation, which typically displays a far more persistent reaction following market crises.

Suggested Citation

  • Andersen, Torben G. & Fusari, Nicola & Todorov, Viktor, 2015. "The risk premia embedded in index options," Journal of Financial Economics, Elsevier, vol. 117(3), pages 558-584.
    • Handle: RePEc:eee:jfinec:v:117:y:2015:i:3:p:558-584
    DOI: 10.1016/j.jfineco.2015.06.005
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    More about this item

    Keywords

    Option pricing; Risk premia; Jumps; Stochastic volatility; Return predictability; Risk aversion; Extreme events;
    All these keywords.

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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