Working Paper: NBER ID: w31833
Authors: Ian Dewbecker; Stefano Giglio
Abstract: The historical returns on equity index options are well known to be strikingly negative. That is typically explained either by investors having convex marginal utility over stock returns (e.g. crash/variance aversion) or by intermediaries demanding a premium for hedging risk. This paper examines the consistency of those explanations with returns on dynamically replicated, or synthetic, options. Theoretically, it derives conditions under which convex marginal utility leads synthetic options to also have negative excess returns. Empirically, synthetic options have CAPM alphas near zero over the period 1926--2022, in stark contrast to exchange-traded options. Over the last 15 years, returns on traded options have converged to those on synthetic options -- with the variance risk premium shrinking towards zero -- while various drivers of the cost and risk of hedging options exposures have declined, consistent with a model in which intermediaries drive option prices.
Keywords: synthetic options; risk preferences; CAPM alphas; intermediaries; hedging risk
JEL Codes: G11; G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| synthetic options (G13) | CAPM alphas near zero (G19) |
| traded options (G13) | strongly negative CAPM alphas (G12) |
| trading and hedging frictions (G19) | gap in returns between true and synthetic options (G17) |
| decrease in trading and hedging frictions (G19) | convergence of returns on traded and synthetic options (G13) |
| convex marginal utility (D11) | negative excess returns on synthetic options (G13) |
| convex marginal utility (D11) | negative CAPM alphas for synthetic options (G13) |