Moneyness, Volatility, and the Cross-Section of Option Returns

Date

2018-03-12

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Working Paper

Peer reviewed

No

Abstract

We study the effect of an asset's volatility on the expected returns of European options written on the asset. A simple stochastic discount factor model suggests that the effect differs depending on whether variations in volatility are due to variations in systematic or idiosyncratic volatility. While variations in idiosyncratic volatility only affect an option's elasticity, variations in systematic volatility also oppositely affect the underlying asset's risk. Since moneyness modulates these effects, systematic volatility positively (negatively) prices options with high (low) asset-to-strike price ratios, while idiosyncratic volatility is unambiguously priced. Single-stock call option data support our predictions.

Description

Keywords

Asset pricing, option returns, moneyness, total, systematic, idiosyncratic volatility

Citation

Aretz, K., Lin, M.T. and Poon, S.H. (2018) Moneyness, Volatility, and the Cross-Section of Option Returns. Working Paper

Rights

Research Institute