Asset Pricing: What We Can Learn From Derivatives
Sunday, Jan. 7, 2018 10:15 AM - 12:15 PM
- Chair: Travis Johnson, University of Texas-Austin
Does the Ross Recovery Theorem Work Empirically?
AbstractStarting with the fundamental relationship that state prices are the product of physical probabilities and the pricing kernel, Ross (2015) shows that, given strong assumptions, knowing state prices suffices for backing out physical probabilities and the pricing kernel at the same time. We find that such recovered physical distributions based on the S&P 500 index are incompatible with future realized returns. This negative result remains, even when we add economically reasonable constraints. Reasons for the rejection seem to be numerical instabilities of the recovery algorithm and the inability of the constrained versions to generate pricing kernels sufficiently away from risk-neutrality.
Margin Requirements and Equity Option Returns
AbstractIn equity option markets, traders face margin requirements both for the options themselves and for hedging-related positions in the underlying stock market. We show that these requirements carry a significant margin premium in the cross-section of equity option returns. The sign of the margin premium depends on demand pressure: If end-users are on the long side of the market, option returns decrease with margins, while they increase otherwise. Our results are statistically and economically significant and robust to different margin specifications and various control variables. We explain our findings by a model of funding-constrained derivatives dealers that require compensation for satisfying end-users' option demand.
- G1 - General Financial Markets