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The Puzzle of Index Option Returns

  • George M. Constantinides

    ()

    (Center for Reserach in Security Prices, University of Chicago and NBER, Booth School of Business, USA)

  • Jens Carsten Jackwerth

    ()

    (Department of Economics, University of Konstanz, Germany)

  • Alexi Savov

    ()

    (Leonard N. Stern School of Business, New York University, USA)

We document that the leverage-adjusted returns on S&P 500 index call and put portfolios are decreasing in their strike-to-price ratio over 1986-2009, contrary to the prediction of the Black-Scholes-Merton model. We test a large number of plausible factor models in order to learn what drives the violations of the Black-Scholes-Merton model. Consistent with the picture that crisis-related factors operate across the equities and index options markets, factors which capture jumps in market volatility, jumps in the market index, and changes in liquidity work reasonably well in explaining the cross-section of index option returns, even when we impose the restriction that the premia are estimated from the universe of equities. Furthermore, the factor that captures jumps in market volatility also reduces the pricing errors of the 25 Fama-French portfolios by more than Size and only a bit less than Value.

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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 2011-17.

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Length: 66 pages
Date of creation: 24 May 2011
Date of revision:
Handle: RePEc:knz:dpteco:1117
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  1. 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.
  2. 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.
  3. Ait-Sahalia, Yacine & Lo, Andrew W., 2000. "Nonparametric risk management and implied risk aversion," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 9-51.
  4. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  5. 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.
  6. 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.
  7. Bates, David S., 2008. "The market for crash risk," Journal of Economic Dynamics and Control, Elsevier, vol. 32(7), pages 2291-2321, July.
  8. Andrea Frazzini & Lasse H. Pedersen, 2012. "Embedded Leverage," NBER Working Papers 18558, National Bureau of Economic Research, Inc.
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