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.