TY - JOUR
T1 - Analyzing volatility risk and risk premium in option contracts
T2 - A new theory
AU - Carr, Peter
AU - Wu, Liuren
N1 - Funding Information:
We thank William Schwert (the editor), Peter Christoffersen (the referee), Torben Anderson, Hans Buehler, Bruno Dupire, Robert Engle, Travis Fisher, Jeremy Graveline, Rachid Lassoued, Alex Levin, Keith Lewis, Dilip Madan, Fabio Mercurio, Attilio Meucci, Alexey Polishchuk, Jason Roth, Angel Serrat, Mridul Tandon, Edward Tom, Ilya Ustilovsky, Arun Verma, Scott Weiner, and seminar participants at Baruch College, the Fields Institute, Northwestern University, Florida State University, Singapore Management University, the 2011 Western Finance Association meetings in Santa Fe, the 2011 China International Conference in Finance in Wuhan, China, and the 2013 Derivatives Conference at New York University for their comments and suggestions. Liuren Wu gratefully acknowledges the support by a grant (ENHC-44-33) from the City University of New York PSC - CUNY Research Award Program.
Publisher Copyright:
© 2016 Elsevier B.V.
Copyright:
Copyright 2016 Elsevier B.V., All rights reserved.
PY - 2016/4/1
Y1 - 2016/4/1
N2 - We develop a new option pricing framework that tightly integrates with how institutional investors manage options positions. The framework starts with the near-term dynamics of the implied volatility surface and derives no-arbitrage constraints on its current shape. Within this framework, we show that just like option implied volatilities, realized and expected volatilities can also be constructed specific to, and different across, option contracts. Applying the new theory to the S&P 500 index time series and options data, we extract volatility risk and risk premium from the volatility surfaces, and find that the extracted risk premium significantly predicts future stock returns.
AB - We develop a new option pricing framework that tightly integrates with how institutional investors manage options positions. The framework starts with the near-term dynamics of the implied volatility surface and derives no-arbitrage constraints on its current shape. Within this framework, we show that just like option implied volatilities, realized and expected volatilities can also be constructed specific to, and different across, option contracts. Applying the new theory to the S&P 500 index time series and options data, we extract volatility risk and risk premium from the volatility surfaces, and find that the extracted risk premium significantly predicts future stock returns.
KW - Expected volatility surface
KW - Implied volatility surface
KW - Option realized volatility
KW - Proportional variance dynamics
KW - Vega-gamma-vanna-volga
KW - Volatility risk premium
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U2 - 10.1016/j.jfineco.2016.01.004
DO - 10.1016/j.jfineco.2016.01.004
M3 - Article
AN - SCOPUS:84955620709
SN - 0304-405X
VL - 120
SP - 1
EP - 20
JO - Journal of Financial Economics
JF - Journal of Financial Economics
IS - 1
ER -