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The Risk Premia Embedded in Index Options

Torben Andersen (), Nicola Fusari () and Viktor Todorov ()
Additional contact information
Nicola Fusari: The Johns Hopkins University Carey Business School, Postal: The Johns Hopkins University Carey Business School, Baltimore, MD 21202, USA
Viktor Todorov: Northwestern University, Postal: Department of Finance, Kellogg School of Management, Northwestern University, Evanston, IL 60208, USA

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: We study the dynamic relation between market risks and risk premia using time series of index option surfaces. We find that priced left tail risk cannot be spanned by market volatility (and its components) and introduce a new tail factor. This tail factor has no incremental predictive power for future volatility and jump risks, beyond current and past volatility, but is critical in predicting future market equity and variance risk premia. Our findings suggest a wide wedge between the dynamics of market risks and their compensation, with the latter typically displaying a far more persistent reaction following market crises.

Keywords: Option Pricing; Risk Premia; Jumps; Stochastic Volatility; Return Predictability; Risk Aversion; Extreme Events (search for similar items in EconPapers)
JEL-codes: C51 C52 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn, nep-ore, nep-rmg and nep-upt
Date: 2018-01-15
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ftp://ftp.econ.au.dk/creates/rp/18/rp18_07.pdf (application/pdf)

Related works:
Journal Article: The risk premia embedded in index options (2015) Downloads
Working Paper: The Risk Premia Embedded in Index Options (2014) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:aah:create:2018-07

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