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The Puzzle of Index Option Returns

Author

Listed:
  • George M. Constantinides

    () (University of Chicago and NBER, USA)

  • Jens Carsten Jackwerth

    () (Department of Economics, University of Konstanz, Germany)

  • Alexi Savov

    () (New York University, USA)

Abstract

We construct a panel of S&P 500 index call and put option portfolios, daily adjusted to maintain targeted maturity, moneyness, and unit market beta, and test multi-factor pricing models. The standard linear factor methodology is applicable because the monthly portfolio returns have low skewness and are close to normal. We hypothesize that any one of crisis-related factors incorporating price jumps, volatility jumps, and liquidity (along with the market) explains the cross sectional variation in returns. Our hypothesis is not rejected, even when the factor premia are constrained to equal the corresponding premia in the cross-section of equities. The alphas of short maturity out-of-the-money puts become economically and statistically insignificant.

Suggested Citation

  • George M. Constantinides & Jens Carsten Jackwerth & Alexi Savov, 2012. "The Puzzle of Index Option Returns," Working Paper Series of the Department of Economics, University of Konstanz 2012-35, Department of Economics, University of Konstanz.
  • Handle: RePEc:knz:dpteco:1235
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    File URL: http://www.uni-konstanz.de/FuF/wiwi/workingpaperseries/WP_Constantinides-Jackwerth-Savov_35-12.pdf
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    References listed on IDEAS

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    1. 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.
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    3. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
    4. Andrea Frazzini & Lasse H. Pedersen, 2012. "Embedded Leverage," NBER Working Papers 18558, National Bureau of Economic Research, Inc.
    5. 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.
    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, 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.
    8. George M. Constantinides & Michal Czerwonko & Jens Carsten Jackwerth & Stylianos Perrakis, 2011. "Are Options on Index Futures Profitable for Riskā€Averse Investors? Empirical Evidence," Journal of Finance, American Finance Association, vol. 66(4), pages 1407-1437, August.
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    Citations

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    Cited by:

    1. Audrino, Francesco & Fengler, Matthias R., 2015. "Are classical option pricing models consistent with observed option second-order moments? Evidence from high-frequency data," Journal of Banking & Finance, Elsevier, vol. 61(C), pages 46-63.
    2. Anisha Ghosh & George M. Constantinides, 2010. "The Predictability of Returns with Regime Shifts in Consumption and Dividend Growth," NBER Working Papers 16183, National Bureau of Economic Research, Inc.
    3. Siddiqi, Hammad, 2015. "Anchoring Heuristic in Option Pricing," Risk and Sustainable Management Group Working Papers 207677, University of Queensland, School of Economics.
    4. Lettau, Martin & Maggiori, Matteo & Weber, Michael, 2014. "Conditional risk premia in currency markets and other asset classes," Journal of Financial Economics, Elsevier, vol. 114(2), pages 197-225.
    5. Lai, Ya-Wen, 2017. "Macroeconomic factors and index option returns," International Review of Economics & Finance, Elsevier, vol. 48(C), pages 452-477.
    6. Bianconi, Marcelo & MacLachlan, Scott & Sammon, Marco, 2015. "Implied volatility and the risk-free rate of return in options markets," The North American Journal of Economics and Finance, Elsevier, vol. 31(C), pages 1-26.
    7. Tafadzwa Mugwagwa & Vikash Ramiah & Imad Moosa, 2015. "The Profitability of Option-Based Contrarian Strategies: An Empirical Analysis," International Review of Finance, International Review of Finance Ltd., vol. 15(1), pages 1-26, March.
    8. Hammad, Siddiqi, 2015. "Index Option Returns from an Anchoring Perspective," MPRA Paper 65331, University Library of Munich, Germany.
    9. Siddiqi, Hammad, 2014. "Anchoring Heuristic in Option Prices," MPRA Paper 66018, University Library of Munich, Germany, revised 15 Jul 2015.
    10. Yichuan Wang & Thomas Eisenbach & Martin Schmalz & Marianne Andries, 2017. "The Term Structure of the Price of Variance Risk," 2017 Meeting Papers 1641, Society for Economic Dynamics.
    11. Siddiqi, Hammad, 2015. "Anchoring and Adjustment Heuristic in Option Pricing," MPRA Paper 68595, University Library of Munich, Germany.
    12. Zhiguo He & Bryan Kelly & Asaf Manela, 2016. "Intermediary Asset Pricing: New Evidence from Many Asset Classes," NBER Working Papers 21920, National Bureau of Economic Research, Inc.
    13. Alan Moreira & Tyler Muir, 2016. "Volatility Managed Portfolios," NBER Working Papers 22208, National Bureau of Economic Research, Inc.
    14. Andries, Marianne & Eisenbach, Thomas M. & Schmalz, Martin C. & Wang, Yichuan, 2015. "The term structure of the price of variance risk," Staff Reports 736, Federal Reserve Bank of New York.
    15. Siddiqi, Hammad, 2015. "Anchoring Heuristic in Option Pricing," MPRA Paper 63218, University Library of Munich, Germany.
    16. Jackwerth, Jens Carsten & Slavutskaya, Anna, 2016. "The total benefit of alternative assets to pension fund portfolios," Journal of Financial Markets, Elsevier, vol. 31(C), pages 25-42.

    More about this item

    Keywords

    index option mispricing; linear factor pricing; price jumps; volatility jumps; volatility; liquidity; delevered returns;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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