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.