Research

S. Barratt, J. Tuck, and S. Boyd: "Convex Optimization Over Risk-Neutral Probabilities"

March 15, 2020

We consider a collection of derivatives that depend on the price of an underlying asset at expiration or maturity. The absence of arbitrage is equivalent to the existence of a risk-neutral probability distribution on the price; in particular, any risk neutral distribution can be interpreted as a certificate establishing that no arbitrage exists. We are interested in the case when there are multiple risk-neutral probabilities. We describe a number of convex optimization problems over the convex set of risk neutral price probabilities.

G. DeSimone: "Emergency Rate Cuts and Beware of the Bull Steepener"

March 6, 2020

On March 3, 2020, the Federal Reserve announced its first emergency rate cut since the Financial Crisis in order to combat mounting Coronavirus fears. This rate trimming of 50 basis points from 1.75% was intended to calm markets and reduce business uncertainty. The rare nature of such actions provides valuable information regarding the current economic backdrop.

G. DeSimone: "Assessing Option Demand from Signed Volume Order Flow"

January 27, 2020

Supply and demand in option markets matter. A critical assumption of popular pricing models, such as Black-Scholes is that investors are subject to a no-arbitrage constraint, which implies a perfect elasticity of supply. In reality, a market maker will not provide endless options contracts without charging higher prices. This demand theory of option pricing is a crucial piece in understanding the behavior of implied volatility surfaces.

G. Bernile, F. Gao, J. Hu: "Center of Volume Mass: Does Options Trading Predict Stock Returns?"

December 17, 2019

We examine whether the distribution of trades along the set of strike prices of option contracts on the same stock contains information about underlying price discovery. We show that option traders’ demand for delta exposure drives the volume-weighted average strike-spot price ratio (VWKS). In turn, we find that VWKS predicts underlying returns and anticipates the flow of fundamental information about the stock. The return predictability is greater but not limited to stocks with higher information asymmetries and arbitrage costs, and becomes stronger ahead of value relevant news.

M. Ma: "Short Selling Risk and Hedge Fund Performance"

December 5, 2019

Hedge funds, on average, outperform other actively managed funds. However, hedge fund managers often use trading strategies that are not used by other managed portfolios, and thus they bear unique risks. In particular, many hedge funds use short selling. I construct an option-based measure of short selling risk as the return spread between the decile of stocks with low option-implied short selling fees and the decile of those with high fees.

J. Duarte, C. Jones, J. Wang: "Very Noisy Option Prices and Inferences Regarding Option Returns"

December 3, 2019

We show that microstructure biases in the estimation of expected option returns and risk premia are large, in some cases over 50 basis points per day. We propose a new method that corrects for these biases. We then apply our method to real data and produce three main findings. First, the expected returns of straddles and delta-hedged options written on the S&P 500 Index are smaller than previously estimated in the literature.

N. Zhu: "Range-Based Expectations"

December 2, 2019

I propose and document empirically that investors form “range-based” expectations – expectations that are influenced by an asset’s past trading range – and that these beliefs affect trading behavior and asset prices. I find that, if an asset’s price is high (low) relative to its 52- week trading range, investors erroneously believe that the asset’s future return distribution is negatively (positively) skewed. Consistent with these beliefs, less sophisticated investors trade options in a way that decreases their exposure to underlying stocks that have a high price relative to their 52-week range; moreover, individual investors are more likely to sell and not buy such stocks.

T. Bali and S. Murray: "In Search of a Factor Model for Optionable Stocks"

December 1, 2019

We propose the first factor model that explains cross-sectional variation in optionable stock returns. Our model includes new factors based on option-implied volatility minus realized volatility, the call minus put implied volatility spread, and the difference between changes in call and put implied volatilities, along with the market factor. The model outperforms previously-proposed factor models at explaining the average returns of portfolios of optionable stocks formed by sorting on other option-based predictors, as well as a large number of other well-known predictors, of the cross section of future stock returns.

A. Doffou: "Tests of the Stochastic Volatility with Jumps Model Driven by Moment Swaps"

November 22, 2019

This paper tests the pricing accuracy and the hedging performance of the stochastic volatility with random jumps model in markets extended to contain swap contracts whose payoffs depend on the realized higher moments of the state variable. Using a two-step iterative approach, latent model variables are first filtered and then used to estimate the model parameters. The tests on European options and variance swaps written on the S&P 500 index show superior pricing accuracies in-sample and out-of-sample and jump risk is priced.

R. Goyenko and C. Zhang: "Option Returns: Closing Prices are not What You Pay"

November 18, 2019

We document that end-of-day equity and index options quoted bid-ask mid-points which are widely used to compute option returns, implied volatilities, and greeks, do not accurately represent trading prices for a day. Delta-hedged option returns computed using these mid-quotes are systematically higher compared to those using any other mid-quote during a day. These differences, which can reach up to 1% per day, are attributed to dynamics of option net order flows, and option market makers inventory position management.

K. Aretz and A. Gazi: "The Early Exercise Risk Premium"

November 16, 2019

We study the asset pricing implications of being able to optimally early exercise a plain-vanilla put option, contrasting the expected returns of American and equivalent European put options. Standard asset pricing models - including models with stochastic volatility and jumps - suggest that the spread in the expected return between the American and European options is positive and widens with a higher early exercise probability, as induced through a higher moneyness, shorter time-to-maturity, or lower underlying-asset volatility.

V. Bogousslavsky and D. Muravyev: "Should We Use Closing Prices? Institutional Price Pressure at the Close"

November 12, 2019

The closing price is the most important stock price of the day, but is it better than alternatives? Closing prices are determined in a special call auction. This single trade accounts for 7.3% of daily stock volume in 2018 and is strongly associated with ETF ownership and institutional rebalancing. Strikingly, this huge volume contributes nothing to price discovery. Closing prices frequently and significantly deviate from closing quote midpoints, but these deviations fully revert overnight.

B. Lotfaliei and C. Lundberg: "Reevaluating the Trade-off Theory of Capital Structure: Evidence from Zero-Leverage Firms"

November 11, 2019

We empirically evaluate extensions to the trade-off theory of capital structure featuring a real option on debt issuance in a zero-leverage environment. Controlling for alternative explanations of zero-leverage behavior, we find considerable evidence in support of the extended trade-off theory and no evidence against it. We validate our empirical approach via simulations under the real option mechanism and under an alternative financially constrained mechanism. The simulations show that our empirical findings are not consistent with zero-leverage behavior driven exclusively by financial constraints, but they are consistent with the real-option mechanism.

J. Cao, X. Ruan, S. Su, W. Zhang: "Pricing VIX Derivatives with Infinite-Activity Jumps"

November 11, 2019

In this paper, we investigate a two-factor VIX model with infinite-activity jumps, which is a more realistic way to reduce errors in pricing VIX derivatives, compared with Mencía and Sentana (2013). Our two-factor model features central tendency, stochastic volatility and infinite-activity pure jump Lévy processes which include the variance gamma (VG) and the normal inverse Gaussian (NIG) processes as special cases. We find empirical evidence that the model with infinite-activity jumps is superior to the models with finite-activity jumps, particularly in pricing VIX options.

L. Piccotti and H. Wang: "Informed Trading Surrounding Data Breaches in Options Markets"

November 11, 2019

We explore whether there is informed trading, which takes advantage of data breach events. By analyzing transactions in the options market, we find two distinct informed trading patterns that begin approximately three months and nine months prior to corporate data-breach announcements, which are supported by evidence of higher trading volume and open interest for put options, a higher put-to-call volume ratio, a higher put-to-call open interest ratio, and lower spreads prior to data-breach announcements.

M. Alfeus, X.J. He, and S.P. Zhu: "An Empirical Study of the Option Pricing Formula with the Underlying Banned from Short Sell"

November 11, 2019

Short sell bans are often imposed during a financial crisis as a desperate measure to stabilize financial markets. Yet, the impact of short sell bans on option pricing and hedging is not well quantitatively studied until very recently when Guo and Zhu (2017) and He and Zhu (2018) formulated a new pricing framework with the underlying being either completely or partially banned from short selling. However, no empirical results were provided to substantiate the usefulness of the formulae, as well as to deepen our understanding on the effects of short sell bans.

L. Schoenleber: "Correlations, Value Factor Returns, and Growth Options"

November 6, 2019

Ex ante (expected) average equity market correlation is linked to the differential correlation dynamics of growth and value firms, as well as the value premium. It predicts the value premium, returns of growth and value firms, and the level of growth options within an economy for horizons up to one year. A production-based asset-pricing model supports the existence of a homogeneous correlation among stocks with similar growth characteristics, depending on the prevailing idiosyncratic firm variance, increasing in the value of growth options and, hence, is connected to the value premium.

A. Pazarbasi, P. Schneider, G. Vilkov: "Sentimental Recovery"

October 31, 2019

We extract subjective risk-neutral and physical distributions from option quotes on S&P 500 and VIX futures according to agents’ sentiment. Without assumptions on preferences or underlying processes, we only impose a good-deal bound on the distributions to recover the bivariate distribution of the S&P 500 and VIX. We devise optimal Sharpe ratio trading strategies in S&P500 and VIX futures markets that are subjective to the agents, and implement them at the observed quotes.

A. Sanford: "Optimized Portfolio Using a Forward-Looking Expected Tail Loss"

October 31, 2019

In this paper, I construct an optimal portfolio by minimizing the expected tail loss (ETL) derived from the forward-looking natural distribution of the Recovery Theorem (RT). The RT is one of the first successful attempts at deriving an unparameterized natural distribution of future asset returns. This distribution can be used as the criterion function in an expected tail loss (ETL) portfolio optimization problem. I find that the portfolio constructed using the RT outperforms both the equally-weighted portfolio and a portfolio constructed using historical ETL.

N. Barberis, L. Jin, B. Wang: "Prospect Theory and Stock Market Anomalies"

October 29, 2019

We present a new model of asset prices in which investors evaluate risk according to prospect theory and examine its ability to explain 22 prominent stock market anomalies. The model incorporates all the elements of prospect theory, takes account of investors’ prior gains and losses, and makes quantitative predictions about an asset’s average return based on empirical estimates of its beta, volatility, skewness, and capital gain overhang. We find that the model is helpful for thinking about a majority of the anomalies we consider.

L. Lochstoer and T. Muir: "Volatility Expectations and Returns"

October 22, 2019

We provide evidence that agents have slow moving beliefs about stock market volatility. This is supported in survey data and is also reflected in firm level option prices. We embed these expectations into an asset pricing model and show that we jointly explain the following stylized facts (some of which are novel to this paper): when volatility increases the equity and variance risk premiums fall or stay flat at short horizons, despite higher future risk; these premiums appear to rise at longer horizons after future volatility has subsided; strategies that time volatility generate alpha; the variance risk premium forecasts stock returns more strongly than either realized variance or risk-neutral variance (VIX); changes in volatility are negatively correlated with contemporaneous returns.

Y.H. Park: "Variance Disparity and Market Frictions"

October 22, 2019

This paper introduces a new model-free approach to measuring the expectation of market variance using VIX derivatives. This approach shows that VIX derivatives carry different information about future variance than S&P 500 (SPX) options, especially during the 2008 financial crisis. I find that the segmentation is associated with frictions such as funding illiquidity, market illiquidity, and asymmetric information. When they are segmented, VIX derivatives contribute more to the variance discovery process than SPX options.

H. Doshi, H. Kim, S. Seo: "What Interbank Rates Tell Us About Time-Varying Disaster Risk"

October 13, 2019

We characterize time-varying disaster risk using interbank rates and their options. The identification of disaster risk has remained a significant challenge due to the rarity of macroeconomic disasters. We make an identification assumption that macroeconomic disasters coincide with banking disasters – extremely unlikely events in which the interbank market fails and investors suffer significant losses. Based on our flexible reduced-form setup, interbank rates together with their options allow us to extract the short-run and long-run components of disaster risk.

G. Duysters, D. Lavie, A. Sabidussi, U. Stettner: "What Drives Exploration? Convergence and Divergence of Exploration Tendencies Among Alliance Partners and Competitors"

October 10, 2019

Management research has alluded to organizational and environmental conditions that drive firms’ tendencies to explore versus exploit. We complement this research by developing theory on vicarious learning to explain how a firm adjusts its own exploration level based on the exploration levels of its alliance partners and competitors. Using panel data on 180 electronics firms publicly traded in the U.S., we reveal an inverted U-shaped association between the firm’s exploration tendency and the exploration levels of its partners and competitors.

J. Driessen, J. Koeter, O. Wilms: "Behavioral in the Short-run and Rational in the Long-run? Evidence from S&P 500 Options"

October 1, 2019

We estimate the pricing kernel from options on the S&P 500 index for different horizons and over time. This allows us to compare short- and long-term pricing kernels and analyze their time-series variation. We show that the well documented pricing kernel puzzle — that is, the non-monotonicity of the pricing kernel — only exists for short horizons. For longer horizons the puzzle disappears and the level, shape and time-series variation of the pricing kernel are in line with standard rational expectation asset pricing models.

C. Pflueger, E. Siriwardane, A. Sunderam: "Financial Market Risk Perceptions and the Macroeconomy"

September 23, 2019

We propose a novel measure of risk perceptions: the price of volatile stocks (PVSt), defined as the book-to-market ratio of low-volatility stocks minus the book-to-market ratio of high-volatility stocks. PVSt is high when perceived risk directly measured from surveys and option prices is low. When perceived risk is high according to our measure, safe asset prices are high, risky asset prices are low, the cost of capital for risky firms is high, and real investment is forecast to decline.

F. Bellini, E. Rroji, C. Sala: "Implicit Quantiles and Expectiles"

September 19, 2019

We compute nonparametric and forward-looking option-implied quantile and expectile curves, and we study their properties on a 5 year dataset of weekly options written on the S&P 500 Index. After studying the dynamics of the single curves and their joint behaviour, we investigate the potentiality of these quantities for risk management and forecasting purposes. As an alternative form of variability mesaures, we compute option implied interquantile and interexpectile differences, that are compared with a weekly VIX like index.

G. Hu and Y. Liu: "The Pricing of Volatility and Jump Risks in the Cross-Section of Index Option Returns"

September 16, 2019

In the data, out-of-the-money (OTM) S&P 500 call and put options both have puzzling low average returns. Existing studies relate these results to models with non-standard preferences. We argue that the low returns on OTM index options are primarily due to the pricing of market volatility risk. When volatility risk is priced, expected option returns match the average returns of call and put options across all strikes as well as returns of option portfolios.

Y. Hen and F. Liu: "The Information Content of The Implied Volatility Surface: Can Option Prices Predict Jumps?"

September 16, 2019

We ask whether option prices contain information on the likelihood and direction of jumps in the underlying stock prices. Applying the partial least squares (PLS) approach to the entire surface of the implied volatilities (IV), we show that option prices can successfully predict downward jumps in stock prices, but not upward jumps. The PLS estimated downward jump factor can predict stock returns with a spread of 1.53% per month between stocks predicted to have the lowest probability of downward jumps and stocks predicted to have the highest probability of downward jumps.

M. Kruttli, B. Roth Tran, S. Watugala: "Pricing Poseidon: Extreme Weather Uncertainty and Firm Return Dynamics"

September 11, 2019

This paper investigates the uncertainty dynamics surrounding extreme weather events through the lens of financial markets. Our framework identifies market responses to the uncertainty regarding both potential hurricane landfall and subsequent economic impact. Stock options on firms with establishments exposed to the landfall region exhibit large increases in implied volatility of up to 30 percent, reflecting impact uncertainty. Impact uncertainty persists for several months after landfall. Using hurricane forecasts, we show both landfall uncertainty and potential impact uncertainty are reflected in option prices before landfall.

T. Andersen, I. Archakov, L. Grund, N. Hautsch, S. Nasekin, I. Nolte, M. Pham, S. Taylor, V. Todorov: "A Descriptive Study of High-Frequency Trade and Quote Option Data"

September 7, 2019

This paper provides a guide to high frequency option trade and quote data disseminated by the Options Price Reporting Authority (OPRA). First, we present a comprehensive overview of the fragmented U.S. option market, including details on market regulation and the trading processes for all 15 constituent option exchanges. Then, we review the general structure of the OPRA dataset and present a thorough empirical description of the observed option trades and quotes for a selected sample of underlying assets that contains more than 25 billion records.

N. Branger, R. Flacke, T.F. Middelhoff: "Jumps and the Correlation Risk Premium: Evidence from Equity Options"

September 5, 2019

This paper breaks the correlation risk premium down into two components: a premium related to the correlation of continuous stock price movements and a premium for bearing the risk of co-jumps. We propose a novel way to identify both premiums based on dispersion trading strategies that go long an index option portfolio and short a basket of option portfolios on the constituents. The option portfolios are constructed to only load on either diffusive volatility or jump risk.

T. Andersen, I. Archakov, : "The Information Content of Short-Term Options"

September 1, 2019

We exploit weekly options on the S&P 500 index to compute the weekly implied variance. We show that the weekly implied variance is a strong predictor of the weekly realized variance. In an encompassing regression test, it crowds out the information content of the monthly implied variance. Further tests reveal that the weekly implied variance outperforms not only the monthly implied variance but also well-established time series models of realized variance.

J. Choi, L. Gallo, R. Hann, H. Kim: "Does Management Guidance Help Resolve Uncertainty around Macroeconomic Announcements?"

August 29, 2019

We examine whether management guidance contains complementary information that helps resolve investor uncertainty around macroeconomic announcements. We find that when firms issue a management earnings forecast in the month prior to a Federal Open Market Committee (FOMC) announcement of the Federal funds rate target, they experience a significantly larger decrease in implied volatility around the announcement. This effect is more pronounced for firms that are more financially constrained and for firms that have greater investment opportunities, consistent with guidance having greater information complementarities when firm investment is more sensitive to interest rate news.

B. Golez and R. Goyenko: "Disagreement in the Equity Options Market and Stock Returns"

August 26, 2019

We estimate investor disagreement from synthetic long and short stock trades in the equity options market. We show that high disagreement predicts low stock returns after positive earnings surprises and high stock returns after negative earnings surprises. These effects are symmetric for stocks, for which short sale constraints are less likely to be binding. For speculative high beta stocks, the negative effect is asymmetrically stronger. In the cross-section of all stocks and in the subset of 500 largest companies, high disagreement robustly predicts low monthly and weekly stock returns.

B. Feunou, R. Aliouchkin, R. Tedongap, L. Xu: "The Term Structure of Expected Quadratic Loss and Gain"

August 23, 2019

We document that the term structures of risk-neutral expected squared negative (quadratic loss) and positive (quadratic gain) returns on the S&P 500 are upward sloping on average. These shapes mainly reflect the higher premium required by investors to hedge downside risk, and the belief that potential gains will increase in the long-run. The term structures exhibit substantial time series variation with large negative slopes during crisis periods. Through the lens of Andersen et al.

O. Tosun and I. Kalak: "ETF Ownership and Corporate Cash Holdings"

August 21, 2019

Do exchange-traded funds (ETFs) influence corporate cash-holding decisions? Consistent with the managerial learning channel from the stock market, we document strong evidence that firms included in ETF baskets have higher cash-holding levels. We address endogeneity concerns through instrumental variable, dynamic generalized methods of moments, and propensity score-matching methods. Further, we identify changes in revenues, external financing, share repurchases, and net working capital as potential channels through which cash holdings increase due to higher ETF ownership.

H. Mohrschladt and J. Schneider: "The Information Content of ITM-Options for Risk-Neutral Skewness and Informed Trading"

August 20, 2019

While the standard to calculate model-free option-implied skewness (MFIS) relies on out-of-the-money (OTM) options, we examine the empirical implications of using in-the-money (ITM) options. First, we show that discarding ITM-options based on liquidity arguments appears unreasonable for individual stock options. Second, we show that the information content of ITM-options provides new economic insights. The positive short-term return predictability of OTM-based MFIS significantly reverses if ITM-options are used instead. This return pattern allows to better attribute the return predictability of MFIS to superior information of investors embedded in option prices rather than skewness preferences.

M. Buchner and B. Kelly: "A Factor Model for Option Returns"

August 19, 2019

Due to their short lifespans and migrating moneyness, options are notoriously difficult to study with the factor models commonly used to analyze the risk-return tradeoff in other asset classes. Instrumented principal components analysis (IPCA) solves this problem by tracking contracts in terms of their pricing-relevant characteristics. We recover the latent common risk factors in option returns and the time-varying loadings of individual options on these factors. Five latent factors explain more than 90% of the variation in a panel of monthly S&P 500 option returns from 1996 to 2017.

B. Hood, J. Huss, R. Israelov, M. Klein: "Risk Parity is Not Short Volatility (Not That There's Anything Wrong with Short Volatility)"

August 15, 2019

There have been increasingly frequent claims that risk parity strategies are hiding an implicit short volatility exposure or behave as though they are short volatility. In order to test the veracity of these claims, we simulate stylized versions of three-asset-class (equity, fixed income, and commodities) risk parity and short volatility strategies, and we compare the trading behavior and returns of each. We conclude that the two strategies’ similarities are overstated, and we find no empirical evidence to support the claimed hidden exposure.

P. Aoun: "Are Affine Volatility Restrictions Still Costly when the Pricing Kernel is Quadratic?"

August 14, 2019

I compare the quadratic kernel used by Christoffersen, Heston and Jacobs (2013) with the commonly used Rubinstein’s (1976) power pricing kernel in terms of option valuation performance. I do so in both affine and nonaffine GARCH(1,1) models. I find that, in both cases, the quadratic kernel outperforms its linear counterpart. I find no evidence that the performance gap between the affine and the nonaffine models shrinks with the quadratic kernel.

I. Filippou, P. Garcia-Ares, F. Zapatero: "Short Squeeze Uncertainty and Skewness"

August 13, 2019

Short squeezes often lead to sudden, large increases in stock prices. We show that uncertainty about the likelihood of a short squeeze is a proxy for skewness-seeking investors, and they use call options in their quest. In particular, these investors are willing to pay a premium for the upside potential of these lottery-like securities, as is the case for other lottery-like securities identified in the literature. In addition, high short squeeze uncertainty causes deviations from the put–call parity condition in the direction dictated by the overpricing of the call options.

N. Augenblick and E. Lazarus: "Restrictions on Asset-Price Movements Under Rational Expectations: Theory and Evidence"

August 13, 2019

How restrictive is the assumption of rational expectations in asset markets? We provide two contributions to address this question. First, we derive restrictions on the admissible variation in asset prices in a general class of rational-expectations equilibria. The challenge in this task is that asset prices reflect both beliefs and preferences. We gain traction by considering market-implied, or risk-neutral, probabilities of future outcomes, and we provide a mapping between the variation in these probabilities and the minimum curvature of utility — or, more generally, the slope of the stochastic discount factor — required to rationalize the marginal investor’s beliefs.

C. Cao, D. Gempesaw, T. Simin: "Information Choice, Uncertainty, and Expected Returns"

August 10, 2019

We investigate how information choices impact equity returns and risk. Building upon the theory of Van Nieuwerburgh and Veldkamp (2010), we estimate a learning index that reflects the expected benefits of learning about an asset. High learning index stocks have 6.2% lower returns per year and an order of magnitude lower abnormal volatilities compared to low learning index stocks. Long run patterns in returns and volatilities, other measures of information flow, and the information environment surrounding earnings announcements confirm our interpretation of the learning index.

H.S. Chen and S. Sabherwal: "Overconfidence Among Option Traders"

August 1, 2019

The investor overconfidence theory predicts a direct relationship between market-wide turnover and lagged market return. Whereas previous research has examined this prediction in the equity market, we focus on trading in the options market. Controlling for stock market cross-sectional volatility, stock idiosyncratic risk, and option market volatility, we find that option trading turnover is positively related to past stock market return. In addition, call option turnover and call to put ratio are also positively associated with the past stock market return.

B. Lin, K. Tan, L. Zhang: "Do Exchange Traded Funds Affect Corporate Cash Holdings?"

August 1, 2019

We examine the effects of corporate ownership by exchange traded funds (ETFs) on corporate cash holdings. Using a panel regression, we show that firms increase their cash holdings to hedge against higher anticipated stock risks induced by ETFs. To establish a causality interpretation, we use the exogenous changes to membership in the Russell index as an instrument for ETF ownership. We further show that shareholders place a higher value on additional cash held by firms with higher ETF ownership and these findings are more pronounced in financially constrained firms and good governance firms.

G. DeSimone: "Min Vol: More than a Safety Trade"

July 26, 2019

Minimum volatility strategies are having a scorching run in 2019. This year min volatility funds are boasting outperformance above the benchmark in a largely bull market, with IShares Min Vol ETF (USMV) gaining 22% against S&P 500’s 19%. These figures may come across as surprising; min vol is typically pitched as safety trade with better downside protection than the market, but less upside potential. Is minimum volatility purely a defensive portfolio solution?

J. Londono, N. Xu: "Variance Risk Premium Components and International Stock Return Predictability"

July 19, 2019

In this paper, we document and explain the distinct behaviors of U.S. downside and upside variance risk premiums (DVP and UVP, respectively) and their international stock return predictability patterns. DVP, the compensation for bearing downside variance risk, is positive, highly correlated with the total variance premium, and countercyclical, whereas UVP is, on average, borderline positive and procyclical with large negative spikes around episodes of market turmoil. We then provide robust evidence that decomposing VP into its downside and upside components significantly improves domestic and international stock return predictability.

J. Londono: "US Equity Tail Risk and Currency Risk Premia"

July 8, 2019

We find that a US equity tail risk factor constructed from out-of-the-money S&P 500 put option prices explains the cross-sectional variation of currency excess returns. Currencies highly exposed to this factor offer a low currency risk premium because they appreciate when US tail risk increases. In a reduced-form model, we show that country-specific tail risk factors are priced in the cross section of currency returns only if they contain a global risk component.

G. DeSimone: "Amplified Momentum"

June 18, 2019

This article takes a deeper look at the drivers of the momentum factor. A traditional momentum strategy involves buying winners and selling losers based on the past 12 months returns. This strategy can be amplified by selecting stocks within the Winner-minus-Loser portfolio that have high implied idiosyncratic volatility (IVOL), extracted from option prices. The short portfolio of high IVOL loser stocks generates significant underperformance, due these stocks being overpriced by investors for their lottery-like payoffs.

A. Kostakis, K. Gkionisy, K. Stathopoulos: "Manifestations of Political Uncertainty around US Presidential Elections: Cross-Sectional Evidence from the Option Market"

June 7, 2019

This study examines the effects of political uncertainty around US presidential elections on firm risk, expected return, trading activity, and dispersion of investor beliefs. To this end, we utilize information embedded in short-term options and exploit cross-sectional differences in firms’ political features, such as their sensitivity to economic policy uncertainty, their stock returns’ exposure to the presidential party, their geographical political alignment with the presidential party, and their political connectedness through campaign contributions.

S. Huang, T. Lin, W. Zheng: "Substitution between Short Selling and Options Trading in Predicting Aggregate Stock Returns"

May 31, 2019

Splitting stocks into groups with and without options trading, we find that only the aggregate short interest index constructed by the stocks without options trading predicts market returns in both in-sample and out-of-sample tests. The return predictability is up to six months and does not revert. Similarly, when splitting stocks into groups based on short selling risks, we find only the aggregate option implied volatility spread constructed by the stocks with higher short selling risks predicts market returns.

P. Launhardta, F. Miebs : "Aggregate Implied Cost of Capital, Option Implied Information and Equity Premium Predictability "

May 30, 2019

The aggregate implied cost of capital (ICC) from analyst estimates finds a variety of applications in finance and is documented to predict the equity premium. Yet, the construction of the analyst-based ICC is data intensive and imposes restrictions on the employed analyst estimates. We suggest a new way to obtain a market-wide ICC using implied information from index options. We show that the resulting ICC predicts the equity premium in- and out-of-sample.

H., Leyla J. Han, X. Pan, L. Xu : "The Cross-section of monetary policy announcement premium"

May 23, 2019

We show that monetary policy announcements require a significant risk compensation in the cross-section of equity returns. Empirically, we use the expected reduction in implied volatility after FOMC announcements to measure the sensitivity of stock returns with respect to monetary policy announcements and find a significant monetary policy announcement premium. We develop a model of macroeconomic announcements to account for the cross-section of the monetary policy announcement premium in equity returns.

T. Frederik Middelhoﬀ: "The Pricing of Market and Idiosyncratic Jump and Volatility Risks"

April 29, 2019

This paper analyzes the risk-return relation of different variance components in the cross-section of option and stock returns. Using option portfolios that have a constant exposure to either jump or diffusive risk, I decompose variance risk into four components: market volatility risk, idiosyncratic volatility risk, market jump risk, and idiosyncratic jump risk. The lion’s share of stocks’ variance risk is paid for the idiosyncratic components, with Sharp Ratios of -3.44 for idiosyncratic jump risk and 2.

Y. Liu, L. Piccotti: "Are Options Redundant? The Benefits of Synthetic Diversification"

April 29, 2019

This paper examines an alternative avenue through which trading in options can expand investors’ opportunity sets, unrelated to private information, differing opinions, endowments, or trading restrictions in the stock market. Investors can synthetically replicate the return profile of optionable stocks using options for a fraction of the cost of holding the underlying securities, which makes diversification more cost-efficient. We find that the option to stock volume ratio increases when stock price, idiosyncratic risk, stock illiquidity, borrowing cost, and market risk aversion are high.

P. Mason, S. Utke: "Investor Taxes and Option Prices"

April 22, 2019

In this paper, we examine how option prices reflect capital gains taxes, if at all. To our knowledge, existing empirical option pricing literature largely ignores the potential impact of taxes on option prices. To assess the effect of taxes on option prices, we exploit a unique setting where “index” options on the S&P 500 Index (SPX) and nearly identical “non-index” options on the exchange traded fund (ETF) tracking the S&P 500 Index (SPY) are subject to different tax treatments.

J. Han, M. Linnenluecke, Z. Liu, Z. Pan, Tom Smith: "A general equilibrium approach to pricing volatility risk"

April 12, 2019

This paper provides a general equilibrium approach to pricing volatility. Existing models (e.g., ARCH/GARCH, stochastic volatility) take a statistical approach to estimating volatility, volatility indices (e.g., CBOE VIX) use a weighted combination of options, and utility based models assume a specific type of preferences. In contrast we treat volatility as an asset and price it using the general equilibrium state pricing framework. Our results show that the general equilibrium volatility method developed in this paper provides superior forecasting ability for realized volatility and serves as an effective fear gauge.

Z. Fan, M. Londono, X.Xiao: "US Equity Tail Risk and Currency Risk Premia"

April 1, 2019

We find that a US equity tail risk factor constructed from out-of-the-money S&P 500 put option prices explains the cross-sectional variation of currency excess returns. Currencies highly exposed to this factor offer a low currency risk premium because they appreciate when US tail risk increases. In a reduced-form model, we show that country-specific tail risk factors are priced in the cross section of currency returns only if they contain a global risk component.

B. Healy, C. O'Sullivan: "Dividend capture returns: anomaly or risk premium? Evidence from the equity options markets Information and Equity Premium Predictability"

February 20, 2019

In the run-up to the ex-dividend day a measure based on option implied dividends predicts ex-day abnormal stock returns. These expected ex-dividend day returns increase on stocks where it is less worthwhile to capture the dividend, stocks that are less liquid, stocks with high idiosyncratic risk, and stocks that have experienced a build up in selling pressure. The evidence from the options markets suggests the positive abnormal ex-day returns, net of transactions costs, achieved by institutions skilled in trading are a risk premium for their role in providing liquidity to non-informational stock traders.

D. Muravyev, J. Pollet, N. Pearson: "Understanding Returns to Short Selling Using Option-Implied Stock Borrowing"

December 15, 2018

Measures of short sale constraints and short selling activity strongly predict stock returns. This apparently exploitable predictability is difficult to explain. We partially resolve this puzzle by using measures of the stock borrowing costs paid by short-sellers. We show in portfolio sorts that the returns to short selling, net of stock borrowing costs, are much smaller than the gross returns to shorting or a typical long-short strategy. Option-implied borrowing fees, which reflect option market makers’ borrowing costs and the risks of changes in those costs, are on average only slightly higher than quoted borrowing fees.

D. Toupin, M.H. Gagnon, G. Power: "Forecasting Market Index Volatility Using Ross-Recovered Distributions"

October 26, 2018

According to the Recovery Theorem (Ross, 2015), options data can reveal the market’s true, contemporaneous expectations about a specific future horizon. We implement empirically the theorem’s approach to separate implied (risk-neutral) volatility into 1) Ross-recovered true expected volatility and 2) a risk preference component, using Optionmetrics Ivy option data for the S&P500 index and four European indices (FTSE, CAC, SMI, DAX). This separation leads to better forecasts of realized volatility for all indexes in our sample compared to a traditional benchmark, implied volatility.

K. Hiraki, G. Skiadopoulos: "The Contribution of Frictions to Expected Returns"

September 28, 2018

In this paper, we study the contribution of frictions to expected returns (CFER). In the presence of market frictions, expected returns will be determined not only by risk factors but also by CFER. We derive an option-based formula to estimate CFER within a formal asset pricing setting. Our formula makes no assumptions on the types of frictions nor on investors’ preferences and it enables us to estimate CFER as a simple scaled deviations from put-call parity.

E. Lazarus: "Horizon-Dependent Risk Pricing: Evidence from Short-Dated Options"

September 28, 2018

I present evidence from index options that the price of risk over the value of the S&P 500 increases as the investment horizon becomes shorter. I show first how these risk prices may be estimated from the data, by translating the risk-neutral probabilities implied by options prices into physical probabilities that must provide unbiased forecasts of the terminal outcome. The risk price can be interpreted as the marginal investor’s effective risk aversion, and estimating this value over different option-expiration horizons for the S&P, I find that risk aversion is reliably higher for near-term outcomes than for longer-term outcomes: the market’s relative risk aversion over terminal index values decreases from around 15 at a one-week horizon to around 3 at a 12-week horizon.

P. Van Tassel: "Relative Pricing and Risk Premia in Equity Volatility Markets"

September 1, 2018

This paper provides empirical evidence that volatility markets are integrated through the time-varying term-structure of variance risk premia. These risk premia predict the returns from selling volatility for different horizons, maturities, and products including variance swaps, straddles, and VIX futures. In addition, the paper derives a closed form relationship between the prices of variance swaps and VIX futures. While tightly linked, VIX futures exhibit deviations of varying significance from the no-arbitrage prices and bounds implied by the variance swap market.

P. Ares, L. Filippou, F. Zapatero: "Demand for Lotteries: the Choice Between Stocks and Options"

June 28, 2018

We show that the availability of options to retail investors displaces lottery stocks. We also find that investors are willing to pay substantial premiums only for the lottery characteristics of out-of-the-money options. Moreover, OTM options displace other types of lottery securities in the stock and option markets when available. We find evidence that uninformed traders (e.g., gamblers) may drive lottery trading in OTM options. We also find that the lottery features of OTM options are likely unrelated to the underlying securities, as we observe systematic violations of arbitrage conditions.

A. Vasquez, X. Xiao: "Default Risk and Option Returns"

February 28, 2018

This paper studies the effects of default risk on equity option returns. We examine the cross section of delta-hedged equity option returns for Optionmetrics stock for the period January 1996 to April 2016. We find that options on stocks with high default risk earn significantly lower returns than options on low default risk stocks. The high minus low return spreads for quintile and decile option portfolios sorted by credit rating or default probability range from -1.

P. Borochin, Y. Zhao: "What Information Does Risk Neutral Skewness Contain? Evidence From Momentum Crashes"

February 27, 2018

Stocks with high option-implied risk-neutral skewness (RNS) have positive abnormal returns driven by rebounds following poor performance.This performance reversal in past loser stocks also underlies momentum crashes. Consistent with this commonality, the RNS anomaly is strongest in periods of post-recession rebounds and high market volatility when momentum crashes occur. Furthermore, the momentum anomaly is strongest (weakest) in stocks with the lowest (highest) RNS, indicating a positive relationship between RNS and momentum crashes.

G. DeSimone, P. A. Laux: "The Timing of Variance Risk Premia Around Macroeconomic News Events"

February 1, 2018

The majority of the variance risk premia is concentrated around the time of macroeconomic news announcements. Risk premia embodied in variance futures are negative around such events, consistent with theory. Risk premia in index option straddle positions are also negative around announcements, except that they are positive around Fed Open Market Committee (FOMC) meetings. Upon decomposing the straddle returns, we find that they primarily represent compensation for jump risk. On the other hand, the positive returns on FOMC meetings are due to extraordinary actions by the board to calm volatility.

R.J. McGee, F. McGroarty: "The Risk Premium That Never Was: A Fair Value Explanation of the Volatility Spread"

October 1, 2017

We present a new framework to investigate the profitability of trading the volatility spread, the upward bias on implied volatility as an estimator of future realized volatility. The scheme incorporates the first four option-implied moments in a growth-optimal payoff that is statically replicated using a portfolio of options. Removing the upward bias on implied volatility worsens the likelihood score of risk-neutral densities obtained from S&P 500 index options when they are used as forecasts of the underlying index return distribution.

C. Jones, H. Mo, T. Wang: "Do Option Prices Forecast Aggregate Stock Returns?"

August 7, 2017

In this paper, we show that the difference between the implied volatilities of call and put options on individual equities has strong predictive power for aggregate stock market returns. This predictability is inconsistent with a rational risk premia or liquidity-based explanation. It is, however, consistent with the implied volatility spread capturing private information, based on its ability to forecast future cash flow growth and discount rate shocks.

J. Hull, A. White: "Optimal Delta Hedging for Options"

May 24, 2017

As has been pointed out by a number of researchers, the normally calculated delta does not minimize the variance of changes in the value of a trader’s position. This is because there is a non-zero correlation between movements in the price of the underlying asset and movements in the asset’s volatility. The minimum variance delta takes account of both price changes and the expected change in volatility conditional on a price change.

R. Israelov: "Pathetic Protection: The Elusive Benefits of Protective Puts"

March 23, 2017

Conventional wisdom is that put options are effective drawdown protection tools. Unfortunately, in the typical use case, put options are quite ineffective at reducing drawdowns versus the simple alternative of statically reducing exposure to the underlying asset. This paper investigates drawdown characteristics of protected portfolios via simulation and a study of the CBOE S&P 500 5% Put Protection Index. Unless your option purchases and their maturities are timed just right around equity drawdowns, they may offer little downside protection.

N. Branger, H. Hulsbusch, T. F. Middelhoff: "Idiosyncratic Volatility, its Expected Variation, and the Cross-Section of Stock Returns"

March 3, 2017

This paper explains the negative relation between the realized idiosyncratic volatility (IVOL) and expected returns. Using implicit information from the cross-section of options we extract expectations about the volatility of idiosyncratic volatility (IVOLVOL) in an almost model-free fashion. We show that IVOL is mean-reverting and that IVOLVOL serves as proxy for the meanreversion speed. Running double sorts on both measures reveals no differences in returns or alpha if the mean-reversion is low.

J. Gatheral, I. Matic, Ivan, R. Radoicic, D. Stefanica: "Tighter Bounds for Implied Volatility"

February 26, 2017

We establish bounds on Black-Scholes implied volatility that improve on the uniform bounds previously derived by Tehranchi. Our upper bound is uniform, while the lower bound holds for most options likely to be encountered in practical applications. We further demonstrate the practical effectiveness of our new bounds by showing how the efficiency of the bisection algorithm is improved for a snapshot of SPX options quotes

A. Tosi, A. Ziegler: "The Timing of Option Returns"

February 3, 2017

We document empirically that the returns from shorting out-of-the-money S&P 500 put options are concentrated in the few days preceding their expiration. Back-month options generate almost no returns, and front-month options do so only towards the end of the option cycle. The concentration of the option premium at the end of the cycle reflects changes in options’ risk characteristics. Specifically, options’ convexity risk increases sharply close to maturity, making them more sensitive to jumps in the underlying price.

J. Faias, P. Santa-Clara: "Optimal Option Portfolio Strategies: Deepening the Puzzle of Index Option Mispricing"

February 1, 2017

Traditional methods of asset allocation (such as mean-variance optimization) are not adequate for option portfolios because the distribution of returns is non-normal and the short sample of option returns available makes it difficult to estimate their distribution. We propose a method to optimize a portfolio of European options, held to maturity, with a myopic objective function that overcomes these limitations. In an out-of-sample exercise, incorporating realistic transaction costs, the portfolio strategy delivers a Sharpe ratio of 0.

Y. Yang, Y. Zheng, T.M. Hospedales: "Gated Neural Networks for Option Pricing: Rationality by Design"

November 30, 2016

We propose a neural network approach to price EU call options that significantly outperforms some existing pricing models and comes with guarantees that its predictions are economically reasonable. To achieve this, we introduce a class of gated neural networks that automatically learn to divide-and-conquer the problem space for robust and accurate pricing. We then derive instantiations of these networks that are ‘rational by design’ in terms of naturally encoding a valid call option surface that enforces no arbitrage principles.

D. Hait: "VIX -- Fear of What?"

September 1, 2016

The VIX, while promoted as an indicator of future market volatility, has more to do with present and past market returns than future volatility. Most (98.8%) of the daily variation in the VIX can be explained by current SPX returns and lagged VIX values. Unexplained changes in the VIX are more likely due to contemporaneous market reactions rather than fear of future events. Despite its lack of predictive ability, the VIX could be useful as a hedge against bidirectional jump risk.

P. Borochin, Y. Zhao: "Variation of the Implied Volatility Function and Return Predictability"

August 1, 2016

The variation of the shape of the implied volatility function (IVF) has significant predictive power for future performance, above that previously documented for the shape of the IVF itself. We find that standard deviations of IV spreads describing the shape of the IVF over the current month are negatively correlated with next month’s realized returns. This effect is strongest during expansionary periods, during contractions this relation becomes weaker. Return predictability is strongest in small firms with the most variable IVFs, but IVF variability yields significant return predictability and cross-sectional variation even with size and liquidity controls.

C. Moll, S. Huffman: "The Incremental Information Content of Innovations in Implied Idiosyncratic Volatility"

April 23, 2016

Motivated by mixed evidence related to the pricing of measures of risk, we investigate the information content of innovations in implied idiosyncratic volatility. Using both cross-sectional and time-series methodologies, we find that innovations in implied idiosyncratic volatility explain future returns for a sample of 2,864 optionable firms examined during the 1999-2010 sample period. We find that long-short portfolios formed using innovations in implied idiosyncratic volatility produce much larger abnormal returns than long-short portfolios formed using the level of implied idiosyncratic volatility.

S. C. Anagnostopoulou, A. Ferentinou, P. Tsaousis, A. Tsekrekos: "The Option Market Reaction to Bank Loan Announcements"

March 21, 2016

In this study, we examine the options market reaction to bank loan announcements for the population of US firms with traded options and loan announcements during 1996–2010. We get evidence on a significant options market reaction to bank loan announcements in terms of levels and changes in short-term implied volatility and its term structure, and observe significant decreases in short-term implied volatility, and significant increases in the slope of its term structure as a result of loan announcements.

S. Choy, J. Wei: "Liquidity Risk and Expected Option Returns"

January 13, 2016

Using data from OptionMetrics for the period of 1996 to 2013, we establish the existence of liquidity risk premium in option returns via both sorting analyses and Fama-MacBeth regressions. In leverage-adjusted, hedged returns, the alpha due to liquidity risk ranges from 11.2 basis points to 19.7 basis points per month. In hedged returns unadjusted for leverage, the alpha ranges from 88.8 basis points to 254 basis points per month. In contrast to the findings for stocks and bonds, the liquidity risk premium uncovered in option returns is negative.

W. Farkas, C. Necula, B. Waelchli: "Herding and Stochastic Volatility"

October 30, 2015

In this paper we develop a one-factor non-affine stochastic volatility option pricing model where the dynamics of the underlying is endogenously determined from micro-foundations. The interaction and herding of the agents trading the underlying asset induce an amplification of the volatility of the asset over the volatility of the fundamentals. Although the model is non-affine, a closed form option pricing formula can still be derived by using a Gauss-Hermite series expansion methodology.

J. Martin, G.Wang: "Are Active Managers a Drag on Investor Wealth? Evidence from an Option-Based Estimation"

October 29, 2015

We estimate an option-based value of a fund manager’s conditional market timing skill in bear market states. We combine this value with alpha based estimates of selection skill to give an overall valuation of active management. At the aggregate level, we estimate that the benefit arising from the option value of active fund management in bad times can be large enough to cover its unconditional overall cost. Our analysis suggests that by taking account of the option premium delivered by managers’ bear market timing skills, the longstanding mutual fund underperformance puzzle could be largely rationalized.

M. Cremers, A.Fodor, D. Weinbaum: "Where Do Informed Traders Trade (First)? Option Trading Activity, News Releases, and Stock Return Predictability"

October 1, 2015

We examine patterns of option trading activity around news announcements. Using a database of option volume initiated by traders to open new positions, combined with a database of news releases, we find that option trading activity is unusually high both immediately before news days and on news days. The trading advantage of option traders stems from their ability to analyze publicly available information as well as anticipate upcoming news events. Ahead of news releases, in-formed option traders trade in the direction of the subsequent news release.

A. Manela, A. Moreira: "News Implied Volatility and Disaster Concerns"

October 1, 2015

We construct a text-based measure of uncertainty starting in 1890 using front-page articles of the Wall Street Journal. News implied volatility (NVIX) peaks during stock market crashes, times of policy-related uncertainty, world wars and financial crises. In US post-war data, periods when NVIX is high are followed by periods of above average stock returns, even after controlling for contemporaneous and forward-looking measures of stock market volatility. News coverage related to wars and government policy explains most of the time variation in risk premia our measure identifies.

H. Park, B. Kim, H. Shim: "A Smiling Bear in the Equity Options Market and the Cross-Section of Stock Returns"

July 20, 2015

We propose a measure for the convexity of an option-implied volatility curve, IV convexity, as a forward-looking measure of excess tail-risk contribution to the perceived variance of underlying equity returns. Using equity options data for individual U.S.-listed stocks during 2000-2013, we find that the average return differential between the lowest and highest IV convexity quintile portfolios exceeds 1% per month, which is both economically and statistically significant on a risk-adjusted basis.

P. Schneider, C. Wagner, J. Zechner: "Low Risk Anomalies?"

April 13, 2015

This paper shows theoretically and empirically that beta- and volatility-based low risk anomalies are driven by return skewness. The empirical patterns concisely match the predictions of our model that endogenizes the role of skewness for stock returns through default risk. With increasing downside risk, the standard capital asset pricing model (CAPM) increasingly overestimates expected equity returns relative to firms’ true (skew-adjusted) market risk. Empirically, the profitability of betting against beta/volatility increases with firms’ downside risk, and the risk-adjusted return differential of betting against beta/volatility among low skew firms compared to high skew firms is economically large.

A. Eisdorfer, E. Kohl: "Corporate Sport Sponsorship and Stock Returns: Evidence from the NFL?"

April 5, 2015

Most of the home stadiums/arenas of major-sport teams in the U.S. are sponsored by large publicly traded companies. Using NFL data we find that stock returns to the sponsoring firms are affected by the outcomes of games played in their stadiums. For example, the mean difference between next-day abnormal returns after a win and after a loss of the home team is 50 basis points for Monday night games and 82 basis points for post-season elimination games.

R. Israelov, L. Nielsen: "Still Not Cheap: Portfolio Protection in Calm Markets"

March 17, 2015

Recent equity volatility is near all-time lows. Option prices are also low. Many analysts suggest this represents a good opportunity to purchase put options for portfolio insurance. It is well-known that portfolio insurance is expensive on average, but what about in calm markets? History suggests it still is. We investigate the relationship between option richness and volatility across ten global equity indices. Option prices may be low, but their expected values tend to be even lower.

B. Feunou, M. Jahan-Parvar, C. Okou: "Downside Variance Risk Premium"

February 27, 2015

We propose a new decomposition of the variance risk premium in terms of upside and downside variance risk premia. The difference between upside and downside variance risk premia is a measure of skewness risk premium. We establish that the downside variance risk premium is the main component of the variance risk premium, and that the skewness risk premium is a priced factor with significant prediction power for aggregate excess returns. Our empirical investigation highlights the positive and significant link between the downside variance risk premium and the equity premium, as well as a positive and significant relation between the skewness risk premium and the equity premium.

X. Wesley Wang, Q. Lei: "Volatility Spread and the Stock Market Response to Earnings Announcements"

January 18, 2015

Using a broad sample of earnings announcements, we find that option call and put implied volatilities become increasingly misaligned as the earnings announcement dates (EAD) get closer. The percentage deviation between call and put implied volatilities increases monotonically in the one-month period leading up to the EAD. In addition, the direction of these deviations is consistent with the announcement returns of such earnings releases. More importantly, by adapting the earnings response coefficient (ERC) framework, we find that pre-earnings option trading actually increases rather than decreases the stock market response to the earnings announcements.

J. Joenvaara, M. Kauppila: "Hedge Fund Tail Risk: Performance and Hedging Mechanisms"

January 15, 2015

We decompose hedge fund tail risk into two components: Systematic Conditional Tail Risk (SCTR), which arises predictably from equity market exposure; and Idiosyncratic Conditional Tail Risk (ICTR), which arises from proprietary alpha investment technology. First, we show that low-SCTR hedge funds deliver superior risk-adjusted returns, but not average returns. In contrast, low-ICTR funds provide both higher risk-adjusted returns and also higher average returns. Our results suggest that this better performance could be due more to skillful hedging than to the harvesting of low-risk anomalies.

C. Culp, Y. Nozawa, P. Veronesi: "Option-Based Credit Spreads"

December 17, 2014

Theoretically, corporate debt is economically equivalent to safe debt minus a put option on the firm’s assets. We empirically show that indeed portfolios of long Treasuries and short traded put options (“pseudo bonds”) closely match the properties of traded corporate bonds. Pseudo bonds display a credit spread puzzle that is stronger at short horizons, unexplained by standard risk factors, and unlikely to be solely due to illiquidity. Our option-based approach also offers a novel, model-free benchmark for credit risk analysis, which we use to run empirical experiments on credit spread biases, the impact of asset uncertainty, and bank-related rollover risk.

F. Hollstein, M. Prokopczuk: "Estimating Beta"

December 15, 2014

We conduct a comprehensive comparison of market beta estimation techniques. We study the performance of several historical, time-series model, and option implied estimators for estimating realized market beta. Thereby, we find the hybrid methodology of Buss and Vilkov (2012) to consistently outperform all other approaches. In addition, all other approaches, including fully implied and GARCH-based methods for dynamic conditional beta, are dominated by a simple beta estimate based on historical (co-)variances and a Kalman filter based approach.

S. C. Anagnostopoulou, A. Tsekrekos: "Accounting Quality, Information Risk and Implied Volatility around Earnings Announcements"

October 15, 2014

We examine the impact of accounting quality, used as a proxy for information risk, on the behavior of equity implied volatility around quarterly earnings announcements. Using US data during 1996-2010, we observe that lower (higher) accounting quality significantly relates to higher (lower) levels of implied volatility (IV) around announcements. Worse accounting quality is further associated with a significant increase in IV before announcements, and is found to relate to a larger resolution in IV after the announcement has taken place.

F. Brinkmann, O. Korn: "Risk-Adjusted Option-Implied Moments"

July 3, 2014

Option-implied moments, like implied volatility, contain useful information about an underlying asset’s return distribution, but are derived under the risk-neutral probability measure. This paper shows how to convert risk-neutral moments into the corresponding physical ones. The main theoretical result expresses moments under the physical probability measure in terms of observed option prices and the preferences of a representative investor. Based on this result, we investigate several empirical questions. We show that a model of a representative investor with CRRA utility can explain the variance risk premium for the S&P500 index but fails to capture variance and skewness risk premiums simultaneously.

P. Andreou, A. Kagkadis, P. Maio, D Philip: "Dispersion in Options Traders’ Expectations and Stock Return Predictability"

January 17, 2014

We propose a measure of dispersion in options traders’ expectations about future stock returns by using dispersion in trading volume across strike prices. We find that an increased dispersion in expectations forecasts lower subsequent excess market returns at both short and long horizons. Trading strategies based on the dispersion measure reveal significant utility gains for a mean-variance investor as compared to a buy-hold strategy. Further, the dispersion measure exhibits additional predictive power when combined with the variance risk premium, thus showing that the two variables capture different aspects of the variation in returns.

T. Chemmanur, C. Ornthanalai, P. Kadiyala: "Options on initial Public Offerings"

August 13, 2013

We analyze the determinants and consequences of option listing on IPO firm stock. We find that options are listed earlier on venture-backed and lower-reputation underwriter IPOs (Initial Public Offerings). We find a significant decrease in stock returns immediately after option listing, persisting for a year. Analyzing the determinants of this equity underperformance, we find a permanent threefold increase in short-interest ratio and aggressive insider selling in IPO equity following option listing.

JY. Zhang, Y. Xu, S. Yan: "Attention on Volatility and Options"

July 15, 2013

This paper investigates the impact of retail investor attention, measured by Google search frequency, on option trading and option pricing as well as stock return volatility. We document a significant positive relation between Google search volume and future option trading activity of retail investors. Moreover, retail investors tend to take more bullish option positions following increased attention. Although option implied volatilities initially rise, the long run impact of Google search volume on option prices is negative, albeit small in magnitude.

B. Boyer, K. Vorkink: "Stock Options as Lotteries"

June 20, 2013

We investigate the relationship between ex-ante total skewness and holding returns on individual equity options. Recent theoretical developments predict a negative relationship between total skewness and average returns, in contrast to the traditional view that only coskewness should be priced. We find, consistent with recent theory, that total skewness exhibits a strong and negative relationship with average option returns. The differences in average returns between low and high skewed options is large, ranging from 10 to 50 per cent per week, even after controlling for risk.

D. Chance, T. Hanson, W. Li, J. Muthuswamy: "The Impact of Computational Error on the Volatility Smile"

April 4, 2013

It is well-known that the market prices of options produce implied volatilities that inexplicably vary by exercise price in a pattern often referred to as the volatility smile. This paper shows that not only do market prices produce volatility smiles, but so do model prices. This result occurs because of root finding algorithms, tolerance assumptions, numerical precisions, and quotation finiteness. Moreover, some assumptions result in patterns that resemble the smirks, and skews sometimes observed in market data.

J. Jackwerth, G. Vilkov: "Asymmetric Volatility Risk: Evidence from Option Markets"

February 20, 2013

We show how to extract the expected risk-neutral correlation between risk-neutral distributions of the market index (S&P 500) return and its expected volatility (VIX). Comparing the implied correlation with its realized counterpart reveals a significant index-to-volatility correlation risk premium. It compensates for the fear of rising and enduring volatility due to market crashes and measures a new dimension of risk not covered by other variables. The correlation risk premium asymmetrically focuses on tail risk, unlike the variance risk premium.

S. Figlewski: "What is Risk Neutral Volatility?"

December 2, 2012

A security’s expected payoff under the real world distribution for stock returns includes risk premia to compensate investors for bearing different types of stock market risk. But Black-Scholes and the great majority of derivatives valuation models developed from it produce the same option prices as would be seen under modified probabilities in a world of investors who were indifferent to risk. Implied volatility and other parameters extracted from options market prices embed these modified “risk neutral” probabilities, that combine investors’ objective predictions of the real world returns distribution with their risk preferences.

J. Du, N. Kapadia: "Tail and Volatility Indices from Option Prices"

August 1, 2012

Both volatility and the tail of stock return distributions are impacted by discontinuities or large jumps in the stock price process. In this paper, we construct a model-free jump and tail index by measuring the impact of jumps on the Chicago Board Options Exchange’s VIXindex. Our jump and tail index is constructed from a portfolio of risk-reversals using 30-day index options, and measures time variations in the intensity of return jumps.

H. Chen, S. Ni, S. Joslin: "Demand for Crash Insurance, Intermediary Constraints, and Stock Returns"

March 19, 2012

H. Chen, S. Ni, S. Joslin, “Demand for Crash Insurance, Intermediary Constraints, and Stock Returns,” (Working Paper Series, presented by Hui Chen at the OptionMetrics Research Conference 2013)

G. Constantinides, J. Jackwerth, A. Savov: "The Puzzle of Index Option Returns"

February 20, 2012

We document that leverage-adjusted returns on S&P 500 index call and put portfolios are decreasing in their strike-to-price ratio over 1986-2010, contrary to the prediction of the Black-Scholes-Merton model. We test a large number of plausible unconditional factor models and find that only factors which capture jumps in the market index and market volatility and factors which capture volatility and liquidity reasonably explain the cross-section of index options. The principal finding is that these factors require economically and statistically different factor premia on subsamples split across type (calls and puts), maturity, and moneyness, pointing towards market segmentation and illiquidity.

G. Skiadopoulos and M. Neumann: "Predictable Dynamics in Higher Order Risk-Neutral Moments: Evidence from the S&P 500 Options"

February 20, 2012

We investigate whether there are predictable patterns in the dynamics of higher order risk-neutral moments extracted from the market prices of S&P 500 index options. To this end, we conduct a horse race among alternative forecasting models within an out-of-sample context over various forecasting horizons. We consider both a statistical and an economic setting. We find that higher risk-neutral moments can be statistically forecasted. However, only the one-day-ahead skewness forecasts can be economically exploited.

A. Buss and G. Vilkov: "Measuring Equity Risk with Option-Implied Correlations"

February 20, 2012

We use forward-looking information from option prices to estimate option-implied correlations and to construct an option-implied predictor of factor betas. With our implied market betas, we find a monotonically increasing risk-return relation, not detectable with standard rolling-window betas, with the slope close to the market excess return. Our implied betas confirm a risk-return relation consistent with linear factor models, because, when compared to other beta approaches: (i) they are better predictors of realized betas, and (ii) they exhibit smaller and less systematic prediction errors.

V. DeMiguel et al: "Improving Portfolio Selection Using Option-Implied Volatility and Skewness"

February 20, 2012

Our objective in this paper is to examine whether one can use option-implied information to improve the selection of mean-variance portfolios with a large number of stocks, and to document which aspects of option-implied information are most useful for improving their out-of-sample performance. Portfolio performance is measured in terms of volatility, Sharpe ratio, and turnover. Our empirical evidence shows that using option-implied volatility helps to reduce portfolio volatility. Using option-implied correlation does not improve any of the metrics.

P. Christoffersen, R. Goyenko, et. al: "Illiquidity Premia in the Equity Options Market"

February 20, 2012

Illiquidity is well-known to be a significant determinant of stock and bond returns. We are the first to estimate illiquidity premia in equity option markets using effective spreads for a large cross-section of firms. The risk-adjusted return spread for illiquid over liquid options is 23 bps per day for calls. The spread for puts is somewhat lower but still significant at 13 bps per day. The spread is generally largest for out-of-the money options.

K. Barraclough, and R. Whaley: "Early Exercise of Put Options on Stocks"

February 20, 2012

U.S. exchange-traded stock options are exercisable before expiration. While put options should frequently be exercised early to earn interest, they are not. In this paper, we derive an early exercise decision rule and then examine actual exercise behavior during the period January 1996 through September 2008. We find that more than 3.96 million puts that should have been exercised early remain unexercised, representing over 3.7% of all outstanding puts. We also find that failure to exercise cost put option holders $1.

T. Bali and S. Murray: "Does Risk-Neutral Skewness Predict the Cross-Section of Equity Option Portfolio Returns?"

February 20, 2012

We investigate the pricing of risk-neutral skewness in the stock options market by creating skewness assets comprised of two option positions (one long and one short) and a position in the underlying stock. The assets are created such that exposure to changes in the price of the underlying stock (delta), and exposure to changes in implied volatility (vega) are removed, isolating the effect of skewness. We find a strong negative relation between implied risk-neutral skewness and the returns of the skewness assets, consistent with a positive skewness preference.

A. Buss, C. Schlag, and G. Vilkov: "CAPM with Option-Implied Betas: Another Rescue Attempt"

February 20, 2012

We test the conditional CAPM with time-varying forward-looking betas, assuming a two-state model for the market risk premium. For market state identification we employ a recursive Markov-switching model based on a forward-looking Sentiment factor. The empirical results for our sample of S&P500 constituents for the period from 1996 to 2007 show that in ‘good’ states of the economy the classical CAPM with just the market factor is able to explain the cross-section of expected returns very well, while in ‘bad’ states firm characteristics like size and book-to-market become relevant.

A. Takeyama, N. Constantinou, and D. Vinogradow: "A Framework for Extracting the Probability of Default from Listed Stock Option Prices"

February 20, 2012

This paper develops a framework to estimate the probability of default (PD) implied in listed stock options. The underlying option pricing model measures PD as the intensity of the jump diffusion that the underlying stock price becomes zero. We adopt a two stage calibration algorithm to obtain the precise estimator of PD. In the calibration procedure, we improve the fitness of the option pricing model via the implementation of the time inhomogeneous term structure model in the option pricing model.

W. Jin, J. Livnat, and Y. Zhang: "Option Prices Leading Equity Prices: Do Option Traders Have an Information Advantage?"

January 10, 2012

Recent evidence shows that option volatility skews and volatility spreads between call and put options predict equity returns. This study investigates whether such predictive ability is driven by option traders’ information advantage. We examine the predictive ability of volatility skews and volatility spreads around significant information events including earnings announcements, other firm-specific information events, and events that trigger significant market reactions. Consistent with option traders having an information advantage relative to equity traders before information events, we find that the option measures immediately before these events have higher predictive ability for short-term event returns than they do in a more dated window or before a randomly selected pseudo-event.

L. Stentoft: "What We Can Learn from Pricing 139,879 Individual Stock Options"

December 22, 2011

The GARCH framework has been used for option pricing with quite some success. While the initial work assumed conditional Gaussian innovations, recent contributions relax this assumption and allow for more flexible parametric specifications of the underlying distribution. However, until now the empirical applications have been limited to index options or options on only a few stocks and this using only few potential distributions and variance specifications. In this paper we test the GARCH framework on 30 stocks in the Dow Jones Industrial Average using two classical volatility specifications and 7 different underlying distributions.

T. Goodman, M. Neamtiu, and F. Zhang: "Fundamental Analysis and Option Returns"

December 21, 2011

In the Merton (1973) ICAPM, state variables that capture the evolution of the investor’s opportunity set are necessary to explain observed asset prices. We show that augmenting the CAPM by a measure of market-wide volatility innovation yields a two-factor model that performs well in explaining the cross-section of returns on securities in several asset classes. The consistent pricing of volatility risk (with a negative risk premium) suggests that volatility risk indeed acts as a state variable rather than being just another statistical factor.

D. Muravyev: "Order Flow and Expected Option Returns"

November 23, 2011

The paper presents three pieces of evidence that the inventory risk faced by market-makers has a primary effect on option prices. First, I introduce a simple method for decomposing the price impact of trades into inventory-risk and asymmetric-information components. The components are inferred from the difference between price responses of the market-maker who receives a trade and those who do not. Both price impact components are significant for option trades, but the inventory-risk component is larger.

Z. Dha, E. Schaumburg: "The pricing of volatility risk across asset classes"

November 21, 2011

In the Merton (1973) ICAPM, state variables that capture the evolution of the investor’s opportunity set are necessary to explain observed asset prices. We show that augmenting the CAPM by a measure of market-wide volatility innovation yields a two-factor model that performs well in explaining the cross-section of returns on securities in several asset classes. The consistent pricing of volatility risk (with a negative risk premium) suggests that volatility risk indeed acts as a state variable rather than being just another statistical factor.

A. Takeyama, N. Constantinou, and D. Vinogradov: "A Framework for Extracting the Probability of Default from Listed Stock Option Prices"

November 14, 2011

This paper develops a framework to estimate the probability of default (PD) implied in listed stock options. The underlying option pricing model measures PD as the intensity of the jump diffusion that the underlying stock price becomes zero. We adopt a two stage calibration algorithm to obtain the precise estimator of PD. In the calibration procedure, we improve the fitness of the option pricing model via the implementation of the time inhomogeneous term structure model in the option pricing model.

K. Barraclough, D. Robinson, et. al.: "Using Option Prices to Infer Overpayments and Synergies in M&A Transactions"

October 12, 2011

In this paper, we use call option prices to identify synergies and news from merger and acquisition (M&A) transaction announcements. We find that M&A announcements result in large and approximately equal gains to the bidder and the target on average, with the combined gains being large enough to justify the premium paid to target shareholders. On average, M&A announcements release good news about targets, but bad news about bidders. This suggests that market prices understate true synergy gains, and helps reconcile the generally negative market-based evidence on value-creation in takeovers with their continued prominence in everyday business strategy.

K. Hamidieh: "Estimating the Tail Shape Parameter from Option Prices"

October 10, 2011

This paper investigates whether fundamental accounting information is appropriately priced in the options market. We find that fundamental accounting signals exhibit incremental predictive power with respect to future option returns above and beyond what is captured by implied and historical stock volatility, suggesting that the options market does not fully incorporate fundamental information into option prices. Transaction costs substantially reduce the overall profitability of hedge strategies that exploit the information in these fundamental accounting signals, but the strategies still earn economically and statistically significant returns for options with low transaction costs.

T. Bali, O. Demirtas, and Y. Atilgan: "Implied Volatility Spreads and Expected Market Returns."

October 1, 2011

This paper investigates the intertemporal relation between volatility spreads and expected returns on the aggregate stock market. We provide evidence for a significantly negative link between volatility spreads and expected returns at the daily and weekly frequencies. We argue that this link is driven by the information flow from option markets to stock markets. The documented relation is significantly stronger for the periods during which (i) S&P 500 constituent firms announce their earnings; (ii) cash flow and discount rate news are large in magnitude; and (iii) consumer sentiment index takes extreme values.

M. Chesney, R. Crameri, and L. Mancini: "Detecting Informed Trading Activities in the Options Markets: Appendix on Subprime Financial Crisis"

September 22, 2011

This paper investigates whether fundamental accounting information is appropriately priced in the options market. We find that fundamental accounting signals exhibit incremental predictive power with respect to future option returns above and beyond what is captured by implied and historical stock volatility, suggesting that the options market does not fully incorporate fundamental information into option prices. Transaction costs substantially reduce the overall profitability of hedge strategies that exploit the information in these fundamental accounting signals, but the strategies still earn economically and statistically significant returns for options with low transaction costs.

T.G. Bali and S. Murrary: "Does Risk-Neutral Skewness Predict the Cross-Section of Equity Option Portfolio Returns?”"

July 20, 2011

We investigate the pricing of risk-neutral skewness in the stock options market by creating skewness assets comprised of two option positions (one long and one short) and a position in the underlying stock. The assets are created such that exposure to changes in the price of the underlying stock (delta), and exposure to changes in implied volatility (vega) are removed, isolating the effect of skewness. We find a strong negative relation between implied risk-neutral skewness and the returns of the skewness assets, consistent with a positive skewness preference.

F. Audrino, D. Colangelo: "Semi-parametric forecasts of the implied volatility surface using regression trees"

October 1, 2010

We present a new semi-parametric model for the prediction of implied volatility surfaces that can be estimated using machine learning algorithms. Given a reasonable starting model, a boosting algorithm based on regression trees sequentially minimizes generalized residuals computed as differences between observed and estimated implied volatilities. To overcome the poor predictive power of existing models, we include a grid in the region of interest, and implement a cross-validation strategy to find an optimal stopping value for the boosting procedure.

J. Driessen, P. Maenhout, and G. Vilkov: "The Price of Correlation Risk: Evidence from Equity Options"

June 1, 2010

We study whether exposure to market-wide correlation shocks affects expected option returns, using data on S&P100 index options, options on all components, and stock returns. We find evidence of priced correlation risk based on prices of index and individual variance risk. A trading strategy exploiting priced correlation risk generates a high alpha and is attractive for CRRA investors without frictions. Correlation risk exposure explains the cross-section of index and individual option returns well.

R. Elkamhi, C. Ornthanalai: "Market Jump Risk and the Price Structure of Individual Equity Options"

May 15, 2010

The role of market jump risk premium implicit in individual equity options has not been examined to date. This paper develops a new factor model for equity returns and option pricing that takes into account the market’s diffusive and jump risks. We estimate the model on a large cross section of equity returns and options. We find that market jump risk embedded in equity options is about 3.18%. This magnitude is consistent with those found in index options pricing studies which suggests that the price structure of equity and index options can be explained in a unified framework.

S. Xiaoyan Ni, J. Pan, A.M. Poteshman: "Volatility Information Trading in the Option Market"

May 3, 2010

This study follows the approach of Ni et al. [Ni, S.X., Pan, J., Poteshman, A.M., 2008. Volatility information trading in the option market. Journal of Finance 63, 1059-1091] – based upon the vega-weighted net demand for volatility – to determine whether volatility information exists within the Taiwan options market. Our empirical results show that foreign institutional investors possess the strongest and most direct volatility information, which is realized by the delta-neutral options/futures trades.

L. Tsiaras: "The Forecast Performance of Competing Implied Volatility Measures: The Case of Individual Stocks"

February 20, 2010

This study examines the information content of alternative implied volatility measures for the 30 components of the Dow Jones Industrial Average Index from 1996 until 2007. Along with the popular Black-Scholes and model-free” implied volatility expectations, the recently proposed corridor implied volatility (CIV) measures are explored. For all pair-wise comparisons, it is found that a CIV measure that is closely related to the model-free implied volatility, nearly always delivers the most accurate forecasts for the majority of the firms.

Tse Chun Lin, Xiaolong Lu and Joost Driessen: "The Forecast Performance of Competing Implied Volatility Measures: The Case of Individual Stocks"

February 20, 2010

This study examines the information content of alternative implied volatility measures for the 30 components of the Dow Jones Industrial Average Index from 1996 until 2007. Along with the popular Black-Scholes and model-free” implied volatility expectations, the recently proposed corridor implied volatility (CIV) measures are explored. For all pair-wise comparisons, it is found that a CIV measure that is closely related to the model-free implied volatility, nearly always delivers the most accurate forecasts for the majority of the firms.

M. Cao and J. Wei : "Commonality in Liquidity: Evidence from the Option Market"

February 17, 2010

This study examines the property of liquidity in the option market. Using IvyDB’s OptionMetrics data for the period of January 1, 1996 to December 31, 2004, we establish convincing evidence of commonality in options liquidity. The commonality remains strong even after controlling for the impact of the underlying stock market and other liquidity determinants. Other findings include: 1) the stock market exhibits a much stronger commonality than does the option market, 2) compared with the inventory risk, information asymmetry plays a more dominant role in influencing options liquidity and 3) the market-wide option liquidity depends on the underlying stock market’s movements – for instance, the bid-ask spread of calls decreases (increases) when the overall market goes up (down), while that of puts takes the opposite pattern.

A. Hansis, C. Schlag, G. Vilkov : "The Dynamics of Risk-Neutral Implied Moments: Evidence from Individual Options"

February 1, 2010

We study the estimation, the dynamics, and the predictability of option-implied risk-neutral moments (variance, skewness, and kurtosis) for individual stocks from various perspectives. We first show that it is in the estimation of the higher moments essential to use an interpolation with a narrow grid as well as a wide interval. We show that implied moments are well explained cross-sectionally by a number of firm characteristics. We use the characteristics that have been shown to exhibit correlation with expected returns (like size and the market-to-book ratio of equity).

J. Cao and B. Han: "Option Returns and Individual Stock Volatility"

November 1, 2009

This paper studies the cross-sectional determinants of delta-hedged stock option returns with an emphasis on the pricing of volatility risk. We find that the average delta-hedged option returns are significantly negative for most stocks, and their magnitudes increase monotonically with the volatility of the underlying stock.Writing covered calls on high volatility stocks on average earns about 2% more per month than selling covered calls on low volatility stocks. This spread is higher when it is more difficult to arbitrage between stock and option.

V. Martinez, I.Rosu and C. Bester: "Option Pricing on Cash Mergers"

September 30, 2009

When a cash merger is announced but not completed, there are two main sources of uncertainty related to the target company: the probability of success and the price conditional on the deal failing. We propose an arbitrage-free option pricing formula that focuses on these sources of uncertainty. We test our formula in a study of all cash mergers between 1996 and 2008 which have sufficiently liquid options traded on the target company.

S. Zymler, D. Kuhn, and B. Rustem: "Worst-Case Value-at-Risk of Non-linear Portfolios"

June 21, 2009

Portfolio optimization problems involving Value-at-Risk (VaR) are often computationally intractable and require complete information about the return distribution of the portfolio constituents, which is rarely available in practice. These difficulties are compounded when the portfolio contains derivatives. We develop two tractable conservative approximations for the VaR of a derivative portfolio by evaluating the worst-case VaR over all return distributions of the derivative underliers with given first- and second-order moments.The derivative returns are modelled as convex piecewise linear or—by using a delta-gamma approximation—as (possibly non-convex) quadratic functions of the returns of the derivative underliers.

E. Maberly, R. Pierce, and P. Catania: "Threshold Levels, Strike Price Grid and Other Market Microstructure Issues Associated with Exchange Traded Equity Options"

January 24, 2009

This paper addresses a number of important market microstructure issues associated with exchange traded equity options having significant research implications for studies investigating clustering on option strike prices. Price threshold levels are examined associated with exchange listing and the automatic exercise of equity options as established by the SEC and OCC to carry out their regulatory and oversight responsibilities. Significant changes are documented including motivation for such changes. Market microstructure issues potentially impact equity options research outcomes and one important issue is documenting changes over time to the strike price grid.

M. Ammann, D. Skovmand, and M. Verhofen: "Implied and Realized Volatility in the Cross-Section of Equity Options"

November 1, 2008

Using a complete sample of US equity options, we analyze patterns of implied volatility in the cross-section of equity options with respect to stock characteristics. We find that high-beta stocks, small stocks, stocks with a low-market-to-book ratio, and non-momentum stocks trade at higher implied volatilities after controlling for historical volatility. We find evidence that implied volatility overestimates realized volatility for low-beta stocks, small caps, low-market-to-book stocks, and stocks with no momentum and vice versa.

S.J. Taylor, P.K Yadav, and Y. Zhang: "The Information Content of Implied Volatilities and Model-free Volatility Expectations: Evidence from Options Written on Individual Stocks"

October 8, 2008

S.J. Taylor, P.K Yadav, and Y. Zhang, “The Information Content of Implied Volatilities and Model-free Volatility Expectations: Evidence from Options Written on Individual Stocks,” (Paper presented at the annual meeting of the Financial Management Association International, Grapevine, Texas, 8 – 11 October 2008).

C. Bajlum and Peter Tind Larsen: "Capital Structure Arbitrage: Model Choice and Volatility Calibration"

June 13, 2008

When identifying relative value opportunities across credit and equity markets, the arbitrageur faces two major problems, namely positions based on model misspecification and mismeasured inputs. Using credit default swap data, this paper addresses both concerns in a convergence-type trading strategy. In spite of differences in assumptions governing default and calibration, we find the exact structural model linking the markets second to timely key inputs. Studying an equally-weighted portfolio of all relative value positions, the excess returns are insignificant when based on a traditional volatility from historical equity returns.

C. Bajlum and P.T. Larsen: "Capital Structure Arbitrage: Model Choice and Volatility Calibration"

June 4, 2008

Deviations from put-call parity contain information about future returns. Using the difference in implied volatility between pairs of call and put options to measure these deviations we find that stocks with relatively expensive calls outperform stocks with relatively expensive puts by 51 basis points per week. We find both positive abnormal performance in stocks with relatively expensive calls and negative abnormal performance in stocks with relatively expensive puts, a result which cannot be explained by short sales constraints.

G. Vilkov: "Variance Risk Premium Demystified"

May 8, 2008

We study the dynamics and cross-sectional properties of the variance risk premia embedded in options on stocks and indices, approximated by the synthetic variance swap returns. Several important stylized facts and contributions arise. First, variance risk premia for indices are systematically larger (more negative) than for individual securities. Second, there are systematic cross-sectional differences in the price of variance in individual stocks. Linking variance swaps to firm size/book-to-market, and stock turnover characteristics, an investor gains access to several lucrative long-short strategies with Sharpe Ratios around 2.

P. Carr and L. Wu: "A Simple Robust Link between American Puts and Credit Insurance"

May 7, 2008

We develop a simple robust link between equity out-of-the-money American put options and a pure credit insurance contract on the same reference company. Assuming that the stock price stays above a barrier B>0 before default but drops and remains below a lower barrier

P. Santa-Clara and S. Yan: "Crashes, Volatility, and the Equity Premium: Lessons from S&P500 Options"

May 1, 2008

P. Santa-Clara and S. Yan, “Crashes, Volatility, and the Equity Premium: Lessons from S&P500 Options,” (Working paper, Universidade Nova de Lisboa and University of South Carolina, May 2008).

E. Szado and H. Kazemi: "Collaring the Cube: Protection Options for a QQQ ETF Portfolio"

April 1, 2008

This article assesses the effectiveness of a long collar as a protective strategy. We examine the risk/return characteristics of a passive collar strategy on the Powershares QQQ trust exchange traded fund (Ticker: QQQQ) from March 1999 to March 2008 and find that, over this time period, a 6-month put/1-month call collar provides far superior returns to the buy and hold QQQ strategy at about 1⁄3 of the volatility. Since returns from protective strategies are not normally distributed, we use both Leland alpha and the Stutzer index to measure risk-adjusted performance.

P. Christoffersen, K. Jacobs, C. Ornthanalai: "Exploring Time-Varying Jump Intensities: Evidence from S&P500 Returns and Options"

March 18, 2008

Existing empirical investigations of jump dynamics in returns and volatility are fairly complicated due to the presence of latent factors. We present a new discrete-time frame-work that combines heteroskedastic processes with rich specifications of jumps in returns and volatility. We provide a tractable risk neutralization framework for this class of mod-els allowing for option valuation with separate modeling of risk premia for the jump and normal innovations. Our models can be estimated with ease on returns using standard maximum likelihood techniques, and joint estimation on returns and a large sample of options is also feasible.

S. Asmussen, D. Madan, M. Pistorius: "Pricing Equity Default Swaps under an approximation to the CGMY Levy Model"

February 19, 2008

The Wiener-Hopf factorization is obtained in closed form for a phase type approximation to the CGMY Levy process. This allows, for the approximation, exact computation of first passage times to barrier levels via La place transform inversion. Calibration of the CGMY model to market option prices defines the risk neutral process for which we infer the first passage times of stock prices to 30% of the price level at contract initiation.

E. Bayraktar: "Pricing Options on Defaultable Stocks"

December 21, 2007

We develop stock option price approximations for a model which takes both the risk of default and the stochastic volatility into account. We also let the intensity of defaults be influenced by the volatility. We show that it might be possible to infer the risk neutral default intensity from the stock option prices. Our option price approximation has a rich implied volatility surface structure and fits the data implied volatility well.

J.S. Doran, D. Jiang, and D.R. Peterson: "Short-Sale Constraints and the Non-January Idiosyncratic Volatility Puzzle"

November 7, 2007

Using event studies, we show that short-sale constraints play an important role in the negative relation between idiosyncratic volatility and stock returns. We explore three exogenous events that change short-sale constraints: the IPO lockup period expiration, option introduction, and the recent short-selling ban on financial stocks. Following mitigation of short-sale constraints from the first two events, high idiosyncratic volatility stocks underperform low volatility stocks in the short and long run, and are associated with higher abnormal trading volume.

M. le Roux: "A Long-Term Model of the Dynamics of the S&P500 Implied Volatility Surface"

October 1, 2007

In this paper we present an econometric model of implied volatilities of S&P500 index options. First, we model the dynamics the CBOE VIX index as a proxy for the general level of implied volatilities. We then describe a parametric model of the implied volatility surface for options with a term of up to two years. We show that almost all of the variation in the implied volatility surface can be explained by the VIX index and one or two other uncorrelated factors.

D. Horn, E. Schneider, and G. Vilkov: "Hedging Options in the Presence of Microstructural Noise"

September 26, 2007

In order to use an option pricing model for dynamic hedging an investor will have to calibrate it to a cross-section of option prices. Microstructural noise in option prices results in a set of indistinguishable parametrizations which may give rise to different hedging errors. In our simulation study for the Heston (1993) model, we identify the parameters most important for hedging and show which set of strikes and time to maturity is relevant for the identification of certain parameters.

R. Engle and A. Mistry: "Priced Risk and Asymmetric Volatility in the Cross-Section of Skewness"

July 19, 2007

There have been widespread claims that credit derivatives such as the credit default swap (CDS) have lowered the cost of firms’ debt financing by creating for investors new hedging opportunities and information. However, these instruments also give banks an opaque means to sever links to their borrowers, thus reducing lender incentives to screen and monitor. In this paper, we evaluate the effect that the onset of CDS trading has on the spreads that underlying firms pay at issue when they seek funding in the corporate bond and syndicated loan markets.

E. Eberlein and D.B. Madan: "Sato Processes and the Valuation of Structured Products"

July 3, 2007

We report on the adequacy of using Sato processes to value equity structured products. In models used to price options on realized variance,the latter must be a random variable with a positive variance. An analysis of this variance of realized variance for Sato processes shows that these processes may be suited to option contracts on realized volatility. Nonlinear pricing principles based on hedging to acceptability are outlined for the purpose of pricing structured transactions.

P. Gagliardini, C. Gourieroux, and E. Renault: "Efficient Derivative Pricing by Extended Method of Moments"

May 1, 2007

This paper extends GMM and information theoretic estimation to settings where the conditional moment restrictions are either uniform (i.e. valid for any value of the conditioning variable), or local (i.e. valid for a particular value of the conditioning variable only). The parameter of interest can be either a structural parameter, or a local conditional moment. This is the framework for option pricing based on both historical data on the underlying asset and cross-sectional data on derivative assets,as a consequence of the rather small traded volumes on derivatives.

J. Conrad, R.F. Dittmar, and E. Ghysels: "Skewness and the Bubble"

April 16, 2007

Motivated by the Internet bubble in the late 1990’s and early years of this century, we explore the possibility that higher moments of the returns distribution may be important in explaining security returns. Using a sample of option prices from 1996-2005, we estimate individual securities’ volatility, skewness and kurtosis using the method of Bakshi, Kapadia and Madan(2003). We find that higher moments are strongly related to returns, even after controlling for differences in size and book-to-market.

A. Berndt and A. Ostrovnaya: "Information Flow Between Credit Default Swap, Option and Equity Markets"

March 15, 2007

This paper measures the contribution of the credit default swap (CDS) mar-ket to price discovery relative to equity and equity option markets. We provide a rigorous analysis of whether and to what extent the credit market acquires information prior to the option market, and vice versa. Our results indicate that investors absorb information revealed in the CDS market into option prices within a few days and vice versa. We observe a significant incremental flow of information from CDS to option markets for high-yield firms and following ad-verse earnings announcements.

V. Di Pietro and G. Vainberg: "Systematic Variance Risk and Firm Characteristics in the Equity Options Market"

December 19, 2006

We construct synthetic variance swap returns from prices of traded options to investigate the pricing of systematic variance risk in the equity options market. Cross sectional tests reveal no evidence of a negative market variance risk premium. Furthermore, we show that a class of linear factor models cannot simultaneously explain index and equity option prices. In particular, equity options appear to be underpriced relative to index options. To exploit the mispricing, we analyze an investment strategy known as dispersion trading, which is implemented by going long a portfolio of equity options, and short a portfolio of index options.

K. Danquah, S. Kasera, B. Lee, and S. Ung: "Local Volatility Calibration Using the ‘Most Likely Path"

December 19, 2006

Why are we interested in calibrating a local volatility surface? It is mostly to price dependent exotic options which are not very liquid and the proper market quotes are not available. Local volatility also gives rise to some interesting relative value trading strategies. There are a number of local volatility calibration methods available, but no one agrees on the “perfect” calibration method. There is no single correct answer. Perhaps that is the reason why calibration is not only a science but also an art.

A. Berndt, A. A. Lookman, and I. Obreja: "Default Risk Premia and Asset Returns"

December 18, 2006

This paper investigates the source for common variation in the portion of re-turns observed in U.S. credit markets that is not related to changes in risk free-rates or expected default losses. We extract a latent common component from firm specific changes in default risk premia that is orthogonal to known systematic risk factors during our sample period from 2001 to 2004. Asset pricing tests using returns on Bloomberg-NASD corporate bond indices suggest that our discovered latent changes in default risk premia (DRP) factor is priced in the corporate bond market.

J. Fan and L. Mancini: "Option Pricing with Aggregation of Physical Models and Nonparametric Statistical Learning"

December 9, 2006

Financial models are largely used in option pricing. These physical models capture several salient features of asset price dynamics. The pricing performance can be significantly enhanced when they are combined with nonparametric learning approaches, that empirically learn and correct pricing errors through estimating state price distributions. In this paper, we propose a new semi-parametric method for estimating state price distributions and pricing financial derivatives. This method is based on a physical model guided non parametric approach to estimate the state price distribution of a normalized state variable, called theAutomatic Correction of Errors (ACE) in pricing formulae.

G.M. Constantinides, J.C. Jackwerth, and S. Perrakis: "Mispricing of S&P 500 Index Options"

November 10, 2006

We document widespread violations of stochastic dominance by one-month S&P 500 index call options market over 1986-2006. These violations imply that a trader can improve her expected utility by engaging in a zero-net-cost trade. We allow the market to be incomplete and also imperfect by introducing transaction costs and bid-ask spreads. Even though pre-crash option prices conform to the Black-Scholes-Merton model reasonably well, they are incorrectly priced if the distribution of the index return is estimated from time-series data even with a variety of statistical adjustments.

R. Battalio and P. Schultz: "Options and the Bubble"

October 22, 2006

Many believe that a bubble existed in Internet stocks in the 1999 to 2000 period, and that short-sale restrictions prevented rational investors from driving Internet stock prices to reasonable levels. In the presence of such short-sale constraints, option and stock prices could decouple during a bubble. Using intraday options data from the peak of the Internet bubble, we find almost no evidence that synthetic stock prices diverged from actual stock prices.

M. Cremers, J. Driessen, and P. Maenhout: "Explaining the Level of Credit Spreads: Option-Implied Jump Risk Premia in a Firm Value Model"

October 19, 2006

Prices of equity index put options contain information on the price of systematic downward jump risk. We use a structural jump-diffusion firm value model to assess the level of credit spreads that is generated by option-implied jump risk premia. In our compound option pricing model, an equity index option is an option on a portfolio of call options on the underlying firm values. We calibrate the model parameters to historical information on default risk, the equity premium and equity return distribution, and S&P 500 index option prices.

H.S. Choi and N. Jayaraman: "Is Reversal of Large Stock-Price Declines Caused by Overreaction or Information Asymmetry: Evidence from Stock and Option Markets"

July 22, 2006

We reexamine the role of option markets in the reversal process of stock prices following stock price declines of 10 percent or more. We find that the positive rebounds for non-optionable firms are caused by an abnormal increase in bid-ask spread on and before the large price decline date. On the other hand, the bid-ask spreads for optionable firms decrease on and before the large price decline date. We also find an abnormal increase in open interest and volume in the option market on and before the large price decline date.

G. Bakshi and L. Wu: "Investor Irrationality and the Nasdaq Bubble"

July 22, 2006

This paper investigates whether the rise and fall of the Nasdaq at the turn of the century can be justified by changes in return risk, and whether investors are driven by irrational euphoria with systematic shifts in the market prices of risks (e.g., inexplicable changes in risk aversion and/or subjective probabilities deviating substantially from the objective states of the world). Based on model specification that accommodates fluctuations in both risk levels and market prices of different sources of risks, our analysis provides three new insights.

E. Zitzewitz: "Price Discovery among the Punters: Using New Financial Betting Markets to Predict Intraday Volatility"

July 19, 2006

The migration of financial betting to prediction market exchanges in the last 5 years has facilitated the creation of contracts that do not correspond to a security traded on a traditional exchange. The most popular of these have been binary options on the closing value of Dow Jones Industrial Average (DJIA). Prices of these options imply expectations of volatility over the very short term, and they can be used to construct an index that has significant incremental predictive power, even after controlling for multiple lags of realized volatility and implied volatility from longer-term options.

S. De Wachter: "Simple Option Pricing and the Leverage Effect"

December 19, 2005

This paper develops a nonparametric test to investigate whether any of two classes of “simple” models can rationalize observed option prices. These classes are (i) processes with independent returns and (ii) univariate Markov processes. The practice of recalibration is mimicked by only imposing minimal stability requirements on the candidate pricing models. The main finding is that processes with independent returns are inadequate even for the purpose of fitting the cross-section and term-structure on a single day.

R.B. Evans, C.C. Geczy, D.K. Musto, and A.V. Reed: "Failure is an Option: Impediments to Short Selling and Options Prices"

December 7, 2005

Regulations allow market makers to short sell without borrowing stock, and the transactions of a major options market maker show that in most hard-to-borrow situations, it chooses not to borrow and instead fails to deliver stock to its buyers. Some of the value of failing passes through to option prices: when failing is cheaper than borrowing, the relation between borrowing costs and option prices is significantly weaker. The remaining value is profit to the market maker, and its ability to profit despite the usual competition between market makers appears to result from a cost advantage of larger market makers at failing.

A. Saretto: "Option Returns and the Cross-Sectional Predictability of Implied Volatility"

November 1, 2005

I study the cross-section of realized stock option returns and find an economically important source of predictability in the cross-sectional distribution of implied volatility. A zero-cost trading strategy that is long in straddles with a large positive forecast of the change in implied volatility and short in straddles with a large negative forecast produces an economically important and statistically significant average monthly return. The results are robust to different market conditions, to firm risk-characteristics, to various industry groupings, to options liquidity characteristics, and are not explained by linear factor models.

M.J. Brennan, X. Liu, Y. Xia: "Option Pricing Kernels and the ICAPM"

June 29, 2005

We estimate the parameters of pricing kernels that depend on both aggregate wealth and state variables that describe the investment opportunity set, using FTSE 100 and S&P 500 index option returns as the returns to be priced. The coefficients of the state variables are highly significant and remarkably consistent across specifications of the pricing kernel, and across the two markets. The results provide further evidence that, consistent with Merton’s (1973) Intertemporal Capital Asset Pricing Model, state variables in addition to market risk The failure of simple complete markets option pricing models of the Black-Scholes (1973) type points to the importance in option pricing of state variables other than the underlying asset price.

S. Xiaoyan Ni, N.D. Pearson, and A.M. Poteshman: "Stock Price Clustering on Option Expiration Dates"

May 19, 2005

This paper presents striking evidence that option trading changes the prices of underlying stocks. In particular, we show that on expiration dates the closing prices of stocks with listed options cluster at option strike prices. On each expiration date, the returns of option able stocks are altered by an average of at least 16.5 basis points, which translates into aggregate market capitalization shifts on the order of $9 billion. We provide evidence that hedge rebalancing by option market makers and stock price manipulation by firm proprietary traders contribute to the clustering.

N. Halov and F. Heider: "Capital Structure, Risk and Asymmetric Information"

April 29, 2005

This paper argues that firms may not issue debt in order to avoid the adverse selection cost of debt. Theory suggests that since debt is a concave claim, it may be mispriced when outside investors are uninformed about firms’ risk. The empirical literature has however paid little attention the caveat that the “lemons” problem of external financing first identified by Myers (1984) only leads to debt issuance, i.e. a pecking order, if debt is risk free or, if it is risky, that it is not mispriced.

S.T.Bharath and T. Shumway: "Forecasting Default with the KMV-Merton Model"

April 26, 2005

This paper argues that firms may not issue debt in order to avoid the adverse selection cost of debt. Theory suggests that since debt is a concave claim, it may be mispriced when outside investors are uninformed about firms’ risk. The empirical literature has however paid little attention the caveat that the “lemons” problem of external financing first identified by Myers (1984) only leads to debt issuance, i.e. a pecking order, if debt is risk free or, if it is risky, that it is not mispriced.

J. McDowell: "A Look at the Market’s Reaction to the Announcements of SEC Investigations"

April 1, 2005

The Securities and Exchange Commission was formed as a result of the stock market crash of 1929. During the crash, the market value of securities listed on the New York Stock Exchange dropped 83%, from $89 billion to $15 billion. Some of the causes of the crash were found to be a pre-crash speculative frenzy, artificially inflated trading activity, false and misleading information published by companies listed on the exchange, and insider trading.

P. Carr and L. Wu: "Stock Options and Credit Default Swaps: A Joint Framework for Valuation and Estimation"

March 19, 2005

We propose a dynamically consistent framework that allows joint valuation and estimation of stock options and credit default swaps written on the same reference company. We model default as controlled by a Poisson process with a stochastic default arrival rate. When default occurs, the stock price drops to zero. Prior to default, the stock price follows a continuous process with stochastic volatility. The instantaneous default rate and instantaneous diffusion variance rate follow a bivariate continuous Markov process, with its dynamics specified to capture the empirical evidence on stock option prices and credit default swap spreads.

R. Popovic and D. Goldsman: "An Examination of Forward Volatility"

December 19, 2004

This paper investigates the adequacy of various principal components (p.c.) approaches as data reduction schemes for processing contingent claim valuations on baskets of equities. As a general proposition we are interested in discovering possible features and rules-of-thumb for the applicability of p.c. techniques. In particular, what accuracy does one lose in valuation-hedging schemes as the dimensionality of the p.c. space is reduced? We also have an interest in validating the posted “stylized” facts of implied volatility as they apply to our data sets.

P. Santa-Clara and A. Saretto: "Option Strategies: Good Deals and Margin Calls"

December 8, 2004

We investigate the risk and return of a wide variety of trading strategies involving options on the S&P 500. We consider naked and covered positions, straddles,strangles, and calendar spreads, with different maturities and levels of money ness.Overall, we find that strategies involving short positions in options generally compensate the investor with very high Sharpe ratios, which are statistically significant even after taking into account the non-normal distribution of returns.Furthermore, we find that the strategies’ returns are substantially higher than warranted by asset pricing models.

R. Sen: "Modeling the Stock Price Process as a Continuous Time Jump Process"

June 19, 2004

An important aspect of the stock price process, which has of ten been ignored in the nancial literature, is that prices on organized exchanges are restricted to a grid. We consider continuous-time models for the stock price process with random waiting times of jumps and discrete jump size. We consider a class of jump processes that are close “to the Black-Scholes model in the sense that as the jump size goes to zero, the jump model converges to geometric Brownianmotion.

J. Pan and A.M. Poteshman: "The Information in Option Volume for Stock Prices"

September 4, 2003

We find strong evidence that option trading volume contains information about future stock price movements. Taking advantage of a unique dataset from the ChicagoBoard Options Exchange, we construct put to call ratios for underlying stocks, using volume initiated by buyers to open new option positions. Performing daily cross-sectional analyses from 1990 to 2001, we find that buying stocks with low put/call ratios and selling stocks with high put/call ratios generates an expected return of 40basis points per day and 1 percent per week.

E. Ofek, M. Richardson, and R.F. Whitelaw: "Limited Arbitrage and Short Sales Restrictions: Evidence from the Options Markets"

January 3, 2003

We investigate empirically the well-known put–call parity no-arbitrage relation in the presence of short sales restrictions. Violations of put–call parity are asymmetric in the direction of short sales constraints, and their magnitudes are strongly related to the cost and difficulty of short selling. These violations are also related to both the maturity of the option and the level of valuations in the stock market, consistent with a behavioral finance theory of over-optimistic stock investors and market segmentation.

P. Carr and L. Wu: "Static Hedging of Standard Options"

November 12, 2002

We consider the hedging of options when the underlying assetprice is exposed to the possibility ofjumps of random size. Working in a single factor Markovian setting, we derive a new, static spanningrelation between a given option and a continuum of shorter-term options written on the same asset.We implement this static relation using a finite set of shorter-term options and use Monte Carlosimulation to determine the hedging error. We compare this hedging error to that of a delta hedgingstrategy based on daily rebalancing in the underlying futures.

D. Hait: "Dividend Forecasts, Option Pricing Models, and Implied Volatility Calculations: Why Simpler is Better"

March 1, 2001

For the purposes of calculating option prices or implied volatilities, the use of a dividend forecasting model based on projected actual dividend growth rates can lead to an option model which is internally inconsistent. In contrast, the use of a model based on constant dividend yields is not only consistent, but also easier to implement. Regardless of the method of handling future dividend payments, any associated errors in the forecast dividend rate will in general result have only a small impact on calculated option implied volatilities, even for long-dated options.

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G. DeSimone: "Emergency Rate Cuts and Beware of the Bull Steepener"

G. DeSimone: "Assessing Option Demand from Signed Volume Order Flow"

G. DeSimone: "Min Vol: More than a Safety Trade"

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