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Option-implied volatility factors and the cross-section of market risk premia

Junye Li ()

Journal of Banking & Finance, 2012, vol. 36, issue 1, 249-260

Abstract: The main goal of this paper is to study the cross-sectional pricing of market volatility. The paper proposes that the market return, diffusion volatility, and jump volatility are fundamental factors that change the investors’ investment opportunity set. Based on estimates of diffusion and jump volatility factors using an enriched dataset including S&P 500 index returns, index options, and VIX, the paper finds negative market prices for volatility factors in the cross-section of stock returns. The findings are consistent with risk-based interpretations of value and size premia and indicate that the value effect is mainly related to the persistent diffusion volatility factor, whereas the size effect is associated with both the diffusion volatility factor and the jump volatility factor. The paper also finds that the use of market index data alone may yield counter-intuitive results.

Keywords: Stochastic discount factor; Volatility components; Volatility risk premia; Value and size effects; Unscented Kalman filter (search for similar items in EconPapers)
JEL-codes: G12 G13 C32 (search for similar items in EconPapers)
Date: 2012
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Handle: RePEc:eee:jbfina:v:36:y:2012:i:1:p:249-260