Why Does Volatility Uncertainty Predict Equity Option Returns?

Jie Jay Cao (), Aurelio Vasquez (), Xiao Xiao () and Xintong Eunice Zhan
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Jie Jay Cao: School of Accounting and Finance, The Hong Kong Polytechnic University, Hong Kong
Aurelio Vasquez: ITAM, Mexico City, Mexico
Xiao Xiao: Bayes Business School, City University of London, London, UK
Xintong Eunice Zhan: School of Management, Fudan University, Shanghai, P. R. China

Quarterly Journal of Finance (QJF), 2023, vol. 13, issue 01, 1-35

Abstract: Delta-hedged option returns consistently decrease in volatility of volatility changes (volatility uncertainty), for both implied and realized volatilities. We provide a thorough investigation of the underlying mechanisms including model-risk and gambling-preference channels. Uncertainty of both volatilities amplifies the model risk, leading to a higher option premium charged by dealers. Volatility of volatility-increases, rather than that of volatility-decreases, contributes to the effect of implied volatility uncertainty, supporting the gambling-preference channel. We further strengthen this channel by examining the effects of option end-users net demand and lottery-like features, and by decomposing implied volatility changes into systematic and idiosyncratic components.

Keywords: Delta-hedged option returns; volatility uncertainty; volatility-of-volatility; model risk; gambling preference (search for similar items in EconPapers)
JEL-codes: C58 D80 G10 G12 (search for similar items in EconPapers)
Date: 2023
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DOI: 10.1142/S2010139223500052

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