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Variance risk, Financial intermediation, and the cross-section of expected option returns


Schürhoff, Norman; Ziegler, Alexandre (2011). Variance risk, Financial intermediation, and the cross-section of expected option returns. NCCR 712, University of Zurich.

Abstract

We explore the pricing of variance risk by decomposing stocks' total variance into systematic and idiosyncratic return variances. While systematic variance risk exhibits a negative price of risk, common shocks to the variances of idiosyncratic returns carry a large positive risk premium. This implies investors pay for insurance against increases (declines) in systematic (idiosyncratic) variance, even though both variances comove countercyclically. Common
idiosyncratic variance risk is an important determinant for the cross-section of expected option returns. These findings reconcile several phenomena, including the pricing differences between index and stock options, the cross-sectional variation in stock option expensiveness,the volatility mispricing puzzle, and the signifcant returns earned on various option portfolio strategies. Our results are consistent with theories of financial intermediation under capital constraints.

We explore the pricing of variance risk by decomposing stocks' total variance into systematic and idiosyncratic return variances. While systematic variance risk exhibits a negative price of risk, common shocks to the variances of idiosyncratic returns carry a large positive risk premium. This implies investors pay for insurance against increases (declines) in systematic (idiosyncratic) variance, even though both variances comove countercyclically. Common
idiosyncratic variance risk is an important determinant for the cross-section of expected option returns. These findings reconcile several phenomena, including the pricing differences between index and stock options, the cross-sectional variation in stock option expensiveness,the volatility mispricing puzzle, and the signifcant returns earned on various option portfolio strategies. Our results are consistent with theories of financial intermediation under capital constraints.

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Additional indexing

Item Type:Working Paper
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:20 August 2011
Deposited On:21 Jul 2011 07:17
Last Modified:05 Apr 2016 14:57
Series Name:NCCR
Number of Pages:69
Related URLs:https://fisher.osu.edu/blogs/efa2011/
http://ideas.repec.org/p/cpr/ceprdp/8268.html
Permanent URL: https://doi.org/10.5167/uzh-48748

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