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Cross section of option returns and idiosyncratic stock volatility

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  • Cao, Jie
  • Han, Bing

Abstract

This paper presents a robust new finding that delta-hedged equity option return decreases monotonically with an increase in the idiosyncratic volatility of the underlying stock. This result cannot be explained by standard risk factors. It is distinct from existing anomalies in the stock market or volatility-related option mispricing. It is consistent with market imperfections and constrained financial intermediaries. Dealers charge a higher premium for options on high idiosyncratic volatility stocks due to their higher arbitrage costs. Controlling for limits to arbitrage proxies reduces the strength of the negative relation between delta-hedged option return and idiosyncratic volatility by about 40%.

Suggested Citation

  • Cao, Jie & Han, Bing, 2013. "Cross section of option returns and idiosyncratic stock volatility," Journal of Financial Economics, Elsevier, vol. 108(1), pages 231-249.
  • Handle: RePEc:eee:jfinec:v:108:y:2013:i:1:p:231-249
    DOI: 10.1016/j.jfineco.2012.11.010
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Byeong-Je An & Andrew Ang & Turan G. Bali & Nusret Cakici, 2014. "The Joint Cross Section of Stocks and Options," Journal of Finance, American Finance Association, vol. 69(5), pages 2279-2337, October.
    2. Choy, Siu-Kai, 2015. "Retail clientele and option returns," Journal of Banking & Finance, Elsevier, vol. 51(C), pages 26-42.
    3. repec:pal:assmgt:v:17:y:2016:i:6:d:10.1057_jam.2016.6 is not listed on IDEAS
    4. repec:eee:dyncon:v:82:y:2017:i:c:p:312-330 is not listed on IDEAS
    5. Nguyen, Duc Binh Benno & Prokopczuk, Marcel & Wese Simen, Chardin, 2017. "International Tail Risk and World Fear," Hannover Economic Papers (HEP) dp-620, Leibniz Universit├Ąt Hannover, Wirtschaftswissenschaftliche Fakult├Ąt.
    6. Chaudhury, Mo, 2017. "Volatility and expected option returns: A note," Economics Letters, Elsevier, vol. 152(C), pages 1-4.
    7. Adam Zaremba, 2016. "Is there a low-risk anomaly across countries?," Eurasian Economic Review, Springer;Eurasia Business and Economics Society, vol. 6(1), pages 45-65, April.
    8. Adam ZAREMBA, 2015. "Low Risk Anomaly In The Cee Stock Markets," Journal for Economic Forecasting, Institute for Economic Forecasting, vol. 0(3), pages 81-102, September.
    9. Birru, Justin & Wang, Baolian, 2016. "Nominal price illusion," Journal of Financial Economics, Elsevier, vol. 119(3), pages 578-598.
    10. Kanne, Stefan & Korn, Olaf & Uhrig-Homburg, Marliese, 2016. "Stock Illiquidity, option prices, and option returns," CFR Working Papers 16-08, University of Cologne, Centre for Financial Research (CFR).
    11. Barras, Laurent & Malkhozov, Aytek, 2016. "Does variance risk have two prices? Evidence from the equity and option markets," Journal of Financial Economics, Elsevier, vol. 121(1), pages 79-92.
    12. Laurent Barras & Aytek Malkhozov, 2015. "Does variance risk have two prices? Evidence from the equity and option markets," BIS Working Papers 521, Bank for International Settlements.
    13. Cao, Jie & Han, Bing, 2016. "Idiosyncratic risk, costly arbitrage, and the cross-section of stock returns," Journal of Banking & Finance, Elsevier, vol. 73(C), pages 1-15.

    More about this item

    Keywords

    Option return; Idiosyncratic volatility; Market imperfections; Limits to arbitrage;

    JEL classification:

    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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