Working Paper: CEPR ID: DP6239
Authors: Mark Broadie; Mikhail Chernov; Michael Johannes
Abstract: This paper studies the returns from investing in index options. Previous research documents significant average option returns, large CAPM alphas, and high Sharpe ratios, and concludes that put options are mispriced. We propose an alternative approach to evaluate the significance of option returns and obtain different conclusions. Instead of using these statistical metrics, we compare historical option returns to those generated by commonly used option pricing models. We find that the most puzzling finding in the existing literature, the large returns to writing out-of-the-money puts, is not even inconsistent with the Black-Scholes model. Moreover, simple stochastic volatility models with no risk premia generate put returns across all strikes that are not inconsistent with the observed data. At-the-money straddle returns are more challenging to understand, and we find that these returns are not inconsistent with explanations such as jump risk premia, Peso problems, and estimation risk.
Keywords: jump risk premia; jump-diffusion models; options returns; put pricing puzzle
JEL Codes: C13; G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| large returns from writing out-of-the-money puts (G13) | not inconsistent with the Black-Scholes model (G19) |
| fluctuating volatility (E32) | EORs more negative (R15) |
| CAPM alphas for out-of-the-money puts (G13) | biased (D91) |
| Merton's jump-diffusion model generates less negative EORs (C58) | when jump risk is not priced (G19) |
| standard factors (P23) | adequately explain the magnitude and statistical significance of put returns (G11) |
| wedge between implied and realized volatility (C58) | challenging to understand at-the-money straddle returns (G13) |