Variance risk, financial intermediation, and the cross-section of expected option returns
We explore the pricing of variance risk by decomposing stocks' total variance into systematic and idiosyncratic return variances. While systematic variance risk exhibits a negative price of risk, common shocks to the variances of idiosyncratic returns carry a large positive risk premium. This implies investors pay for insurance against increases (declines) in systematic (idiosyncratic) variance, even though both variances comove countercyclically. Common idiosyncratic variance risk is an important determinant for the cross-section of expected option returns. These findings reconcile several phenomena, including the pricing differences between index and stock options, the cross-sectional variation in stock option expensiveness, the volatility mispricing puzzle, and the significant returns earned on various option portfolio strategies. Our results are consistent with theories of financial intermediation under capital constraints.
|Date of creation:||Feb 2011|
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- Peter Carr & Liuren Wu, 2004. "Variance Risk Premia," Finance 0409015, EconWPA.
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- repec:wsi:ijtafx:v:14:y:2011:i:06:n:s0219024911006784 is not listed on IDEAS
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- Sentana, E., 2000. "Factor Representing Portfolios in Large Asset Markets," Papers 0001, Centro de Estudios Monetarios Y Financieros-.
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