“Moneyness, Volatility, and the Cross-Section of Equilibrium Option Returns: Theory and Empirical Evidence

Finance

Speaker:Kevin Aretz, University of Manchester
Date: Tuesday 3 May 2016
Time: 13.45
Location: Constantine Leventis

Further details

We use a stochastic discount factor framework to investigate the relationships between a European option’s moneyness, the volatility of the option’s underlying asset, and the expected option return. Under fairly general conditions, moneyness conditions the relationship between expected option return and the underlying’s volatility. Deep enough in-the-money (ITM) call options produce a positive relationship between expected return and volatility, whereas deep enough out-of-the-money (OTM) call options produce a negative relationship. Conversely, deep enough ITM put options produce a negative relationship between expected return and volatility, whereas deep enough OTM put options produce a positive relationship. Using Optionmetrics data, we offer results supporting the above conditioning effect of moneyness on the relationship between the cross-section of call returns and volatility. Our results add to an emerging literature on the cross-section of option returns, but also have the potential to explain several equity pricing puzzles, such as Ang et al.’s (2006) “volatility anomaly” and Campbell et al.’s (2008) “distress anomaly.”