Cross section of option returns and idiosyncratic stock volatility

Jie Cao and Bing Han

Journal of Financial Economics, 2013, vol. 108, issue 1, 231-249

Abstract: This paper presents a robust new finding that delta-hedged equity option return decreases monotonically with an increase in the idiosyncratic volatility of the underlying stock. This result cannot be explained by standard risk factors. It is distinct from existing anomalies in the stock market or volatility-related option mispricing. It is consistent with market imperfections and constrained financial intermediaries. Dealers charge a higher premium for options on high idiosyncratic volatility stocks due to their higher arbitrage costs. Controlling for limits to arbitrage proxies reduces the strength of the negative relation between delta-hedged option return and idiosyncratic volatility by about 40%.

Keywords: Option return; Idiosyncratic volatility; Market imperfections; Limits to arbitrage (search for similar items in EconPapers)
JEL-codes: G02 G12 G13 (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (56)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:108:y:2013:i:1:p:231-249

DOI: 10.1016/j.jfineco.2012.11.010

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