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The Puzzle of Index Option Returns

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Author Info

  • George M. Constantinides

    ()
    (Center for Reserach in Security Prices, University of Chicago and NBER, Booth School of Business, USA)

  • Jens Carsten Jackwerth

    ()
    (Department of Economics, University of Konstanz, Germany)

  • Alexi Savov

    ()
    (Leonard N. Stern School of Business, New York University, USA)

Abstract

We document that the leverage-adjusted returns on S&P 500 index call and put portfolios are decreasing in their strike-to-price ratio over 1986-2009, contrary to the prediction of the Black-Scholes-Merton model. We test a large number of plausible factor models in order to learn what drives the violations of the Black-Scholes-Merton model. Consistent with the picture that crisis-related factors operate across the equities and index options markets, factors which capture jumps in market volatility, jumps in the market index, and changes in liquidity work reasonably well in explaining the cross-section of index option returns, even when we impose the restriction that the premia are estimated from the universe of equities. Furthermore, the factor that captures jumps in market volatility also reduces the pricing errors of the 25 Fama-French portfolios by more than Size and only a bit less than Value.

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Bibliographic Info

Paper provided by Department of Economics, University of Konstanz in its series Working Paper Series of the Department of Economics, University of Konstanz with number 2011-17.

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Length: 66 pages
Date of creation: 24 May 2011
Date of revision:
Handle: RePEc:knz:dpteco:1117

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Related research

Keywords: index option returns; option mispricing; volatility jumps; price jumps; liquidity; market efficiency;

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References

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  1. Itamar Drechsler & Amir Yaron, 2011. "What's Vol Got to Do with It," Review of Financial Studies, Society for Financial Studies, vol. 24(1), pages 1-45.
  2. Yacine Ait-Sahalia & Andrew W. Lo, 2000. "Nonparametric Risk Management and Implied Risk Aversion," NBER Working Papers 6130, National Bureau of Economic Research, Inc.
  3. Bates, David S., 2008. "The market for crash risk," Journal of Economic Dynamics and Control, Elsevier, vol. 32(7), pages 2291-2321, July.
  4. Bates, David S, 1996. "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in Deutsche Mark Options," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 69-107.
  5. George M. Constantinides & Michal Czerwonko & Jens Carsten Jackwerth & Stylianos Perrakis, 2011. "Are Options on Index Futures Profitable for Riskā€Averse Investors? Empirical Evidence," Journal of Finance, American Finance Association, vol. 66(4), pages 1407-1437, 08.
  6. Andrea Frazzini & Lasse H. Pedersen, 2012. "Embedded Leverage," NBER Working Papers 18558, National Bureau of Economic Research, Inc.
  7. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  8. Buraschi, Andrea & Jackwerth, Jens, 2001. "The Price of a Smile: Hedging and Spanning in Option Markets," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 495-527.
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Cited by:
  1. George Constantinides, 2012. "The Predictability of Returns with Regime Shifts in Consumption and Dividend Growth," 2012 Meeting Papers 1197, Society for Economic Dynamics.
  2. Audrino, Francesco & Fengler, Matthias, 2013. "Are classical option pricing models consistent with observed option second-order moments? Evidence from high-frequency data," Economics Working Paper Series 1311, University of St. Gallen, School of Economics and Political Science.
  3. Marcelo Bianconi & Scott MacLachlan & Marco Sammon, 2014. "Implied Volatility and the Risk-Free Rate of Return in Options Markets," Discussion Papers Series, Department of Economics, Tufts University 0777, Department of Economics, Tufts University.
  4. Martin Lettau & Matteo Maggiori & Michael Weber, 2013. "Conditional Risk Premia in Currency Markets and Other Asset Classes," NBER Working Papers 18844, National Bureau of Economic Research, Inc.

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