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The Risk Premia Embedded in Index Options

Author

Listed:
  • Torben G. Andersen

    (Northwestern University and CREATES)

  • Nicola Fusari

    (The Johns Hopkins University Carey Business School)

  • Viktor Todorov

    (Northwestern University)

Abstract

We study the dynamic relation between market risks and risk premia using time series of index option surfaces. We find that priced left tail risk cannot be spanned by market volatility (and its components) and introduce a new tail factor. This tail factor has no incremental predictive power for future volatility and jump risks, beyond current and past volatility, but is critical in predicting future market equity and variance risk premia. Our findings suggest a wide wedge between the dynamics of market risks and their compensation, with the latter typically displaying a far more persistent reaction following market crises.

Suggested Citation

  • Torben G. Andersen & Nicola Fusari & Viktor Todorov, 2018. "The Risk Premia Embedded in Index Options," CREATES Research Papers 2018-07, Department of Economics and Business Economics, Aarhus University.
  • Handle: RePEc:aah:create:2018-07
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    More about this item

    Keywords

    Option Pricing; Risk Premia; Jumps; Stochastic Volatility; Return Predictability; Risk Aversion; Extreme Events;
    All these keywords.

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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