Risk Preferences Implied by Synthetic Options

Ian Dew-Becker and Stefano Giglio

No 31833, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: The historical returns on equity index options are well known to be strikingly negative. That is typically explained either by investors having convex marginal utility over stock returns (e.g. crash/variance aversion) or by intermediaries demanding a premium for hedging risk. This paper examines the consistency of those explanations with returns on dynamically replicated, or synthetic, options. Theoretically, it derives conditions under which convex marginal utility leads synthetic options to also have negative excess returns. Empirically, synthetic options have CAPM alphas near zero over the period 1926--2022, in stark contrast to exchange-traded options. Over the last 15 years, returns on traded options have converged to those on synthetic options -- with the variance risk premium shrinking towards zero -- while various drivers of the cost and risk of hedging options exposures have declined, consistent with a model in which intermediaries drive option prices.

JEL-codes: G11 G12 G13 (search for similar items in EconPapers)
Date: 2023-11
New Economics Papers: this item is included in nep-rmg and nep-upt
Note: AP
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