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Moneyness, Underlying Asset Volatility, and the Cross-Section of Option Returns

Aretz, Kevin and Lin, Ming-Tsung and Poon, Ser-Huang (2022) 'Moneyness, Underlying Asset Volatility, and the Cross-Section of Option Returns.' Review of Finance. ISSN 1382-6662 (In Press)

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We study the effect of an asset’s volatility on the expected returns of European options on the asset. Deriving predictions from a stochastic discount factor model, we show that the effect depends on whether variations in the asset’s volatility are driven by systematic or idiosyncratic volatility. While idiosyncratic-volatility-induced variations only affect the option elasticity, systematic-volatility-induced variations also oppositely affect the expected return of the asset. Since the expected asset return (elasticity) effect dominates for options with more linear (non-linear) payoffs, systematic volatility prices sufficiently in-the-money (out-of-the-money) options with the opposite (same) sign as idiosyncratic volatility. Using single-stock calls as test assets, double-sorted portfolios and Fama-MacBeth (1973) regressions broadly support the model’s predictions.

Item Type: Article
Uncontrolled Keywords: Asset pricing; Option returns; Moneyness; Total, systematic, and idiosyncratic volatility
Divisions: Faculty of Social Sciences
Faculty of Social Sciences > Essex Business School
Faculty of Social Sciences > Essex Business School > Essex Finance Centre
SWORD Depositor: Elements
Depositing User: Elements
Date Deposited: 20 Dec 2021 14:00
Last Modified: 23 May 2022 15:37

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