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The Puzzle of Index Option Returns

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  • George M. Constantinides

    ()
    (University of Chicago and NBER, USA)

  • Jens Carsten Jackwerth

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

  • Alexi Savov

    ()
    (New York University, USA)

Abstract

We construct a panel of S&P 500 index call and put option portfolios, daily adjusted to maintain targeted maturity, moneyness, and unit market beta, and test multi-factor pricing models. The standard linear factor methodology is applicable because the monthly portfolio returns have low skewness and are close to normal. We hypothesize that any one of crisis-related factors incorporating price jumps, volatility jumps, and liquidity (along with the market) explains the cross sectional variation in returns. Our hypothesis is not rejected, even when the factor premia are constrained to equal the corresponding premia in the cross-section of equities. The alphas of short maturity out-of-the-money puts become economically and statistically insignificant.

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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 2012-35.

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Length: 43 pages
Date of creation: 07 Sep 2012
Date of revision:
Handle: RePEc:knz:dpteco:1235

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Related research

Keywords: index option mispricing; linear factor pricing; price jumps; volatility jumps; volatility; liquidity; delevered returns;

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References

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  1. 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.
  2. Jens Carsten Jackwerth & George M. Constantinides & Michal Czerwonko & Stylianos Perrakis, 2008. "Are Options on Index Futures Profitable for Risk Averse Investors? Empirical Evidence," CoFE Discussion Paper 08-08, Center of Finance and Econometrics, University of Konstanz.
  3. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  4. Andrea Frazzini & Lasse H. Pedersen, 2012. "Embedded Leverage," NBER Working Papers 18558, National Bureau of Economic Research, Inc.
  5. 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.
  6. Bates, David S., 2008. "The market for crash risk," Journal of Economic Dynamics and Control, Elsevier, vol. 32(7), pages 2291-2321, July.
  7. Yacine Ait-Sahalia & Andrew W. Lo, 2000. "Nonparametric Risk Management and Implied Risk Aversion," NBER Working Papers 6130, National Bureau of Economic Research, Inc.
  8. 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.
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Cited by:
  1. 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.
  2. 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.
  3. George Constantinides, 2012. "The Predictability of Returns with Regime Shifts in Consumption and Dividend Growth," 2012 Meeting Papers 1197, Society for Economic Dynamics.
  4. 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.

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