Understanding Index Option Returns
AbstractThis 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.
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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6239.
Date of creation: May 2007
Date of revision:
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Other versions of this item:
- C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-05-12 (All new papers)
- NEP-CFN-2007-05-12 (Corporate Finance)
- NEP-RMG-2007-05-12 (Risk Management)
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