Post by Sapphire Capital on Jul 11, 2008 22:09:35 GMT 4
The Price of Market Volatility Risk
JEFFERSON DUARTE
University of Washington
CHRISTOPHER S. JONES
University of Southern California - Finance and Business Economics Department
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October 28, 2007
Abstract:
We analyze the volatility risk premium by applying a modified two-pass Fama-MacBeth procedure to the returns of a large cross section of the returns of options on individual equities. Our results provide strong evidence of a volatility risk premium that is increasing in the level of overall market volatility. This risk premium provides compensation for risk stemming both from the characteristics of the option contract and the riskiness of the underlying equity. We also show with a large scale Monte Carlo simulation that measurement error in option prices and violations of arbitrage bounds induce highly economically significant biases in the mean returns of options. In fact, our simulation results demonstrate that biases can be up to several percentage points per day. These large biases can lead researchers to faulty conclusions with respect to both the magnitude of the volatility risk premium and the sign of expected option returns.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1106960_code48388.pdf?abstractid=1106960&mirid=3
JEFFERSON DUARTE
University of Washington
CHRISTOPHER S. JONES
University of Southern California - Finance and Business Economics Department
--------------------------------------------------------------------------------
October 28, 2007
Abstract:
We analyze the volatility risk premium by applying a modified two-pass Fama-MacBeth procedure to the returns of a large cross section of the returns of options on individual equities. Our results provide strong evidence of a volatility risk premium that is increasing in the level of overall market volatility. This risk premium provides compensation for risk stemming both from the characteristics of the option contract and the riskiness of the underlying equity. We also show with a large scale Monte Carlo simulation that measurement error in option prices and violations of arbitrage bounds induce highly economically significant biases in the mean returns of options. In fact, our simulation results demonstrate that biases can be up to several percentage points per day. These large biases can lead researchers to faulty conclusions with respect to both the magnitude of the volatility risk premium and the sign of expected option returns.
papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1106960_code48388.pdf?abstractid=1106960&mirid=3