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Demand in the Option Market and the Pricing Kernel

Author

Listed:
  • Caio Almeida

    (Princeton University)

  • Gustavo Freire

    (Erasmus University Rotterdam)

Abstract

We show that net demand in the S&P 500 option market is fundamental to explain empirical puzzles related to the pricing kernel. When public investors (non-market makers) are exposed to variance risk by net-selling out-of-the-money (OTM) options, the pricing kernel is U-shaped, expected option returns are low and the variance risk premium is high. Conversely, when public investors are protected against variance risk by net-buying OTM options, the pricing kernel is decreasing in market returns, expected option returns are high and the variance risk premium is low. Our findings support equilibrium models with heterogeneous agents in which options are nonredundant.

Suggested Citation

  • Caio Almeida & Gustavo Freire, 2022. "Demand in the Option Market and the Pricing Kernel," Working Papers 2022-32, Princeton University. Economics Department..
    • Handle: RePEc:pri:econom:2022-32
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    More about this item

    Keywords

    Pricing Kernel; Option Returns; Option Demand; Market Makers; Risk Premium;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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