Dark Matter in (Volatility and) Equity Option Risk Premiums

Gurdip Bakshi, John Crosby and Xiaohui Gao

Papers from arXiv.org

Abstract: Emphasizing the statistics of jumps crossing the strike and local time, we develop a decomposition of equity option risk premiums. Operationalizing this theoretical treatment, we equip the pricing kernel process with unspanned risks, embed (unspanned) jump risks, and allow equity return volatility to contain unspanned risks. Unspanned risks are consistent with negative risk premiums for jumps crossing the strike and local time and imply negative risk premiums for out-of-the-money call options and straddles. The empirical evidence from weekly and farther-dated index options is supportive of our theory of economically relevant unspanned risks and reveals ``dark matter" in option risk premiums.

Date: 2023-03
New Economics Papers: this item is included in nep-fmk and nep-rmg
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