Firm specific option risk and implications for asset pricing

James S. Doran and Andy Fodor

Journal of Risk

Abstract: ABSTRACT This paper examines the marginal impact on portfolio returns and the variability of including firm-specific options as an additional investment in a portfolio with an existing long position in the underlying asset. We find significant negative (positive) abnormal returns to purchasing (writing) put options from January 1996 through to December 2006. An investor can also augment portfolio returns by taking relatively large covered call positions. There is little evidence of increased portfolio value resulting from consistently purchasing any option. Additionally, we find that the premiums from writing put options are not related to any specific firm characteristic, suggesting a pervasive risk premium. Asset pricing tests that include market option factors are unable to explain the returns to portfolios that include firm-specific options. Tests on delta-hedged portfolios confirm that gains to put options are related to idiosyncratic volatility risk and not market volatility risk. This is indicative of an idiosyncratic risk premium for options that is distinct from the idiosyncratic risk of stocks.

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