Working Paper: CEPR ID: DP8268
Authors: Norman Schrhoff; Alexandre Ziegler
Abstract: We explore the pricing of variance risk by decomposing stocks' total variance into systematic and idiosyncratic return variances. While systematic variance risk exhibits a negative price of risk, common shocks to the variances of idiosyncratic returns carry a large positive risk premium. This implies investors pay for insurance against increases (declines) in systematic (idiosyncratic) variance, even though both variances comove countercyclically. Common idiosyncratic variance risk is an important determinant for the cross-section of expected option returns. These findings reconcile several phenomena, including the pricing differences between index and stock options, the cross-sectional variation in stock option expensiveness, the volatility mispricing puzzle, and the significant returns earned on various option portfolio strategies. Our results are consistent with theories of financial intermediation under capital constraints.
Keywords: Asset Pricing; Cross-section of Option Returns; Financial Intermediation; Variance Risk
JEL Codes: G12; G13; G24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Common idiosyncratic variance risk (CIVR) (D81) | Positive risk premium (G19) |
| Systematic variance risk (SVR) (G17) | Negative risk premium (D81) |
| Common idiosyncratic variance risk (CIVR) (D81) | Investors pay for insurance against increases in variance (G52) |
| Financial intermediaries require compensation for bearing CIVR (G19) | Exposure to common movements in idiosyncratic variances (C22) |
| Common idiosyncratic variance risk (CIVR) and systematic variance risk (SVR) (C26) | Pricing differences between index and stock options (G13) |
| Common idiosyncratic variance risk (CIVR) and systematic variance risk (SVR) (C26) | Volatility mispricing puzzle (G19) |