Analyzing volatility risk and risk premium in option contracts: A new theory

Peter Carr, Liuren Wu

Research output: Contribution to journalArticle

Abstract

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.

Original languageEnglish (US)
Pages (from-to)1-20
Number of pages20
JournalJournal of Financial Economics
Volume120
Issue number1
DOIs
StatePublished - Apr 1 2016

Keywords

  • Expected volatility surface
  • Implied volatility surface
  • Option realized volatility
  • Proportional variance dynamics
  • Vega-gamma-vanna-volga
  • Volatility risk premium

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics
  • Strategy and Management

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