Moneyness, Underlying Asset Volatility, and the Cross-Section of Option Returns*

Kevin Aretz, Ming-Tsung Lin and Ser-Huang Poon

Review of Finance, 2023, vol. 27, issue 1, 289-323

Abstract: We study the effect of an asset’s volatility on the expected returns of European options on the asset. Deriving predictions from a stochastic discount factor model, we show that the effect depends on whether variations in the asset’s volatility are driven by systematic or idiosyncratic volatility. While idiosyncratic-volatility-induced variations only affect the option elasticity, systematic-volatility-induced variations also oppositely affect the expected return of the asset. Since the expected asset return (elasticity) effect dominates for options with more linear (non-linear) payoffs, systematic volatility prices sufficiently in-the-money (out-of-the-money) options with the opposite (same) sign as idiosyncratic volatility. Using single-stock calls as test assets, double-sorted portfolios and Fama–MacBeth (1973) regressions broadly support the model’s predictions.

Keywords: Asset pricing; Option returns; Moneyness; Total; systematic; idiosyncratic volatility (search for similar items in EconPapers)
JEL-codes: G11 G12 G15 (search for similar items in EconPapers)
Date: 2023
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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