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Analyzing volatility risk and risk premium in option contracts: A new theory

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  • Carr, Peter
  • Wu, Liuren

Abstract

We develop a new option pricing framework that tightly integrates with how institutional investors manage options positions. The framework starts with the near-term dynamics of the implied volatility surface and derives no-arbitrage constraints on its current shape. Within this framework, we show that just like option implied volatilities, realized and expected volatilities can also be constructed specific to, and different across, option contracts. Applying the new theory to the S&P 500 index time series and options data, we extract volatility risk and risk premium from the volatility surfaces, and find that the extracted risk premium significantly predicts future stock returns.

Suggested Citation

  • Carr, Peter & Wu, Liuren, 2016. "Analyzing volatility risk and risk premium in option contracts: A new theory," Journal of Financial Economics, Elsevier, vol. 120(1), pages 1-20.
    • Handle: RePEc:eee:jfinec:v:120:y:2016:i:1:p:1-20
    DOI: 10.1016/j.jfineco.2016.01.004
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    More about this item

    Keywords

    Implied volatility surface; Option realized volatility; Expected volatility surface; Volatility risk premium; Vega-gamma-vanna-volga; Proportional variance dynamics;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • 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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