The Puzzle of Index Option Returns
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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References listed on IDEAS
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- Ait-Sahalia, Yacine & Lo, Andrew W., 2000.
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- George M. Constantinides & Michal Czerwonko & Jens Carsten Jackwerth & Stylianos Perrakis, 2010. "Are Options on Index Futures Profitable for Risk Averse Investors? Empirical Evidence," NBER Working Papers 16302, National Bureau of Economic Research, Inc.
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- 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.
- 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. Full references (including those not matched with items on IDEAS)