Equity Options and Volatility Derivatives
Friday, Jan. 3, 2020 2:30 PM - 4:30 PM (PDT)
- Chair: Ing-Haw Cheng, Dartmouth College
The Price of Higher Order Catastrophe Insurance: The Case of VIX Options
AbstractWe develop an equilibrium pricing model aimed at explaining observed characteristics in equity returns, VIX futures and VIX options data. To derive our model we first specify a general framework based on affine jump-diffusive state-dynamics and agents endowed with Duffie-Epstein recursive utility. This allows us to derive moments of equity returns under the objective and risk-neutral measures, and subsequently semi-closed form solutions to prices of equity options, VIX futures, and VIX options. We calibrate this model to fit the salient features of the data, including moments of consumption and equity returns, and various features of VIX derivatives data. The model matches the extremely right skewed volatility smiles seen in VIX options, a downward sloping term-structure of implied Black '76 volatilities, large negative rates of return on VIX futures, and negative VIX option risk premia. It also matches other characteristics of VIX options data, including time-variation in the shape of implied volatilities.
Why do option prices predict stock returns?
AbstractOption prices significantly predict stock returns: stocks earn low returns when put options are expensive relative to call options. We attribute most of this predictability to the association between option prices and the conditions in the securities lending market. Writers of put options hedge by shorting the underlying stock; they therefore mark up option prices by the capitalized amount of the expected shorting costs over the life of the option. The implied volatility spread between put and call options aligns with borrowing costs, and this spread predicts changes in future shorting costs. Option prices do not predict stock returns among stocks that are easy to borrow.
Default Risk and Option Returns
AbstractThis paper studies the effects of default risk on equity option returns. In a stylized capital structure model, expected delta-hedged equity option returns have a negative relation with default risk, driven by firm leverage and asset volatility. Empirically, we find that delta-hedged equity option returns monotonically decrease with higher default risk measured by credit ratings or default probability. We also find that default risk is related to the predictability of existing anomalies in the equity option market. For nine out of ten anomalies, the long-short option returns are higher for high default risk firms.
- G1 - General Financial Markets