Download or read book On the Negative Market Volatility Risk Premium written by Alfredo Ibañez and published by . This book was released on 2007 with total page 38 pages. Available in PDF, EPUB and Kindle. Book excerpt: Existing evidence indicates that (i) average returns of purchased delta-hedged options are negative, implying options are expensive, and (ii) volatility is the most important extra risk that is factored into option prices. Therefore, a natural extension is to explain the cross-section of average delta-hedged option returns in a stochastic volatility model. This paper solves this problem by introducing a measure of option overprice, which quantifies the impact on option prices of the volatility risk premium. It is an application of option-pricing in incomplete markets under stochastic volatility. An extensive numerical exercise shows the option overprice is consistent with the cross-section of average delta-hedged returns of calls, puts, and straddles reported by the literature for the Samp;P 500 index, except for expensive short-term out-of-the-money puts. In a stochastic volatility model, the volatility risk of at- and, especially, out-of-the-money calls and puts is several times larger than market volatility, which explains large negative volatility risk premiums if volatility risk is negative priced.

Download or read book Delta Hedged Gains and the Negative Market Volatility Risk Premium written by Nikunj Kapadia and published by . This book was released on 2001 with total page 48 pages. Available in PDF, EPUB and Kindle. Book excerpt: We investigate whether the volatility risk premium is negative by examining the statistical properties of delta-hedged option portfolios (buy the option and hedge with stock). Within a stochastic volatility framework, we demonstrate a correspondence between the sign and magnitude of the volatility risk premium and the mean delta-hedged portfolio returns. Using a sample of Samp;P 500 index options, we provide empirical tests that have the following general results. First, the delta-hedged strategy underperforms zero. Second, the documented underperformance is less for options away from the money. Third, the underperformance is greater at times of higher volatility. Fourth, the volatility risk premium significantly affects delta-hedged gains even after accounting for jump-fears. Our evidence is supportive of a negative market volatility risk premium.

Download or read book Options and the Volatility Risk Premium written by Jared Woodard and published by Pearson Education. This book was released on 2011-02-17 with total page 49 pages. Available in PDF, EPUB and Kindle. Book excerpt: Master the new edge in options trades: the hidden volatility risk premium that exists in options for every major asset class. One of the most exciting areas of recent financial research has been the study of how the volatility implied by option prices relates to the volatility exhibited by their underlying assets. Here, I’ll explain the concept of the volatility risk premium, present evidence for its presence in options on every major asset class, and show how to estimate, predict, and trade on it....

Download or read book On the Relation between the Market Risk Premium and Market Volatility written by Yufeng Han and published by . This book was released on 2002 with total page 51 pages. Available in PDF, EPUB and Kindle. Book excerpt: Intuition derived from the static capital asset pricing theory(CAPM) suggests that the market risk premium should be positively related to the market systematic risk as measured by the market volatility (variance). However, the empirical evidence is conflicting. While some studies find significantly positive relation, others find insignificant or significantly negative relation. This paper attempts to resolve the market risk and return relation puzzle by recognizing that the market volatility is time-varying and should be treated as an important source of systematic risk - volatility risk. Therefore, investors demand a risk premium for bearing the market volatility risk in addition to the market systematic risk. As a result, the market risk premium consists of two components: risk premium on the market systematic risk and risk premium on the market volatility risk. We find strong evidence of a significantly positive relation between the market risk premium and market systematic risk. We also find that the risk premium on the volatility risk, is negative and significant, which distorts the positive market risk and return relationship.

Download or read book Volatility Risk Premiums Embedded in Individual Equity Options written by Nikunj Kapadia and published by . This book was released on 2003 with total page pages. Available in PDF, EPUB and Kindle. Book excerpt: The research indicates that index option prices incorporate a negative volatility risk premium, thus providing a possible explanation of why Black-Scholes implied volatilities of index options on average exceed realized volatilities. This examination of the empirical implication of a market volatility risk premium on 25 individual equity options provides some new insights.While the Black-Scholes implied volatilities from individual equity options are also greater on average than historical return volatilities, the difference between them is much smaller than for the market index. Like index options, individual equity option prices embed a negative market volatility risk premium, although much smaller than for the index option - and idiosyncratic volatility does not appear to be priced.These empirical results provide a potential explanation of why buyers of individual equity options leave less money on the table than buyers of index options.

Download or read book Essays on Volatility Risk Premia in Asset Pricing written by and published by . This book was released on 2008 with total page pages. Available in PDF, EPUB and Kindle. Book excerpt: This thesis contains two essays. In the first essay, we investigate the impact of time varying volatility of consumption growth on the cross-section and time-series of equity returns. While many papers test consumption-based pricing models using the first moment of consumption growth, less is known about how the time-variation of consumption growth volatility affects asset prices. In a model with recursive preferences and unobservable conditional mean and volatility of consumption growth, the representative agent's estimates of conditional moments of consumption growth affect excess returns. Empirically, we find that estimated consumption volatility is a priced source of risk, and exposure to it predicts future returns in the cross-section. Consumption volatility is also a strong predictor of aggregate quarterly excess returns in the time-series. The estimated negative price of risk together with the evidence on equity premium predictability suggest that the elasticity of intertemporal substitution of the representative agent is greater than unity, a finding that contributes to a long standing debate in the literature. In the second essay, I present a simple model to show that if agents face binding portfolio constraints, stocks with high volatility in states of low market returns demand a premium beyond the one implied by systematic risks. Assets whose volatility positively covaries with market volatility also have high expected returns. Both effects of this idiosyncratic volatility risk premium are strongest for assets that face more binding trading restrictions. Unlike the prior empirical literature that obtains mixed results when focusing on the level of idiosyncratic volatility, I investigate the dynamic behavior of idiosyncratic volatility and find strong support for my predictions. Comovement of innovations of idiosyncratic volatility with market returns negatively predicts returns for trading restricted stocks relative to unrestricted stocks, and comovement.

Download or read book Volatility and Time Series Econometrics written by Mark Watson and published by Oxford University Press. This book was released on 2010-02-11 with total page 432 pages. Available in PDF, EPUB and Kindle. Book excerpt: A volume that celebrates and develops the work of Nobel Laureate Robert Engle, it includes original contributions from some of the world's leading econometricians that further Engle's work in time series economics

Download or read book The Volatility Risk Premium Embedded in Currency Options written by Buen Sin Low and published by . This book was released on 2020 with total page 51 pages. Available in PDF, EPUB and Kindle. Book excerpt: This study employs a non-parametric approach to investigate the volatility risk premium in the over-the-counter currency option market. Using a large database of daily delta-neutral straddle quotes in four major currencies - the British pound, the euro, the Japanese yen, and the Swiss franc - we find that volatility risk is priced in all four currencies across different option maturities. We find that the volatility risk premium is negative, with the premium decreasing in maturity. Finally, we also find evidence that jump risk may be priced in the currency option market.

Download or read book The Missing Risk Premium written by Eric G. Falkenstein and published by Createspace Independent Publishing Platform. This book was released on 2012-08-16 with total page 0 pages. Available in PDF, EPUB and Kindle. Book excerpt: Risk is the deviation from the consensus rather than an exposure to a covariance, and this implies there is no risk premium in general. It also implies that when there are a large number of people buying highly volatile assets, such assets will have negative returns in equilibrium. As there are several independent motivations for people to buy highly volatile assets, intuitively risky assets generally have lower-than-average returns. This novel conception of risk implies many things more consistent with the data than the current theory. Risk taking is an important life skill, so understanding its nature is important, and unfortunately academics who study it full-time are like so many other experts: when not irrelevant, 180 degrees wrong. This book explains the current asset pricing theory, and proposes an alternative, using theory and a unique survey of the data across many asset classes. Familiarity with some MBA level finance is helpful but not necessary to appreciate this book.

Download or read book State Dependent Volatility and the Market Risk Premium written by Scott E. Mayfield and published by . This book was released on 1999 with total page 61 pages. Available in PDF, EPUB and Kindle. Book excerpt: The market risk premium is estimated based on the equilibrium relationship between risk and expected returns in an intertemporal setting characterized by periods of distinctly different levels of risk. In this environment of discrete volatility states, expected returns compensate investors for current volatility risk as well as the risk associated with a change in the level of market volatility. More importantly, expected returns include the expected change in market value associated with a change in the level of market risk. For this reason, average realized returns within each volatility state do not reflect the risk premium required by investors for state specific risk. By explicitly modelling the process governing the evolution of volatility states, I recover the required risk premium for each volatility state. The dynamic nature of the volatility process implies a term structure of expected forward risk premia that is dependent upon the current level of market volatility. During the period from 1926 to 1997, my estimates indicate that the economy is likely to have been in the high-volatility state approximately 13 percent of the time and that there is a strong statistical relationship between these high-volatility episodes and business cycle contraction periods. In addition, I find evidence of a structural shift in the volatilty process corresponding to the end of the Great Depression Era. As a result of this structural change, the likelihood of being in the high-volatility state decreases dramatically after 1940, implying a significant decrease in the level of market risk. Consistent with this reduction in risk, I find evidence of an abnormal increase in market values during the period from 1940 to 1960. After controlling for this windfall capital gain, my analysis suggests that the long-run market risk premium for the period after 1940 is substantially less than that implied by the simple historical average of excess market returns.

Download or read book Volatility Risk Premium in FX Market written by and published by . This book was released on 2015 with total page pages. Available in PDF, EPUB and Kindle. Book excerpt: I derive the volatility risk premium in FX market from a consumption based model. High volatility corresponds to low consumption growth of professional FX market participants, so they are ready to pay a premium for holding assets correlated with volatility shocks. This premium is not decreased to zero by households, because they can only participate in FX market through asset managers. Asset managers optimize their utility from performance-based compensation. This makes them behave as if they are owners of the funds deriving all their income from investment activities and they require a compensation for the risks that they take. The size of risk premium is determined by the asset manager's risk aversion and their compensation structure. I test the model prediction that the volatility risk premium is different in FX and stock market and find that the difference in estimates is highly statistically significant.

Download or read book The Influence of Tracking Error on Volatility Premium Estimation written by James Doran and published by . This book was released on 2008 with total page 38 pages. Available in PDF, EPUB and Kindle. Book excerpt: I investigate whether the volatility risk premium is negative in energy and equity markets by examining the statistical properties of delta-gamma hedged option portfolios (selling the option, hedging with the underlying contract, and correcting for tracking error with an additional option). By correcting for gamma, these hedged portfolios are not subject to the same discretization and model misspecification problems as traditional delta-hedged portfolios. Within a stochastic volatility framework, I demonstrate that ignoring an option's gamma can lead to incorrect inference on the magnitude of the volatility risk premium. Using a sample of Samp;P 100 Index and natural gas contracts, empirical tests reveal that the delta-gamma hedged strategy outperforms zero and the degree of over-performance is proportional to the level of volatility.

Download or read book What Does the Volatility Risk Premium Say About Liquidity Provision and Demand for Hedging Tail Risk written by Jianqing Fan and published by . This book was released on 2016 with total page 58 pages. Available in PDF, EPUB and Kindle. Book excerpt: This paper provides a data-driven analysis of the volatility risk premium, using tools from high-frequency finance and Big Data analytics. We argue that the volatility risk premium, loosely defined as the difference between realized and implied volatility, can best be understood when viewed as a systematically priced bias. We first use ultra-high-frequency transaction data on SPDRs and a novel approach for estimating integrated volatility on the frequency domain to compute realized volatility. From that we subtract the daily VIX, our measure of implied volatility, to construct a time series of the volatility risk premium. To identify the factors behind the volatility risk premium as a priced bias we decompose it into magnitude and direction. We find compelling evidence that the magnitude of the deviation of the realized volatility from implied volatility represents supply and demand imbalances in the market for hedging tail risk. It is difficult to conclusively accept the hypothesis that the direction or sign of the volatility risk premium reflects expectations about future levels of volatility. However, evidence supports the hypothesis that the sign of the volatility risk premium is indicative of gains or losses on a delta-hedged portfolio.

Download or read book Dynamic Estimation of Volatility Risk Premia and Investor Risk Aversion from Option implied and Realized Volatilities written by Tim Bollerslev and published by . This book was released on 2004 with total page 60 pages. Available in PDF, EPUB and Kindle. Book excerpt: "This paper proposes a method for constructing a volatility risk premium, or investor risk aversion, index. The method is intuitive and simple to implement, relying on the sample moments of the recently popularized model-free realized and option-implied volatility measures. A small-scale Monte Carlo experiment suggests that the procedure works well in practice. Implementing the procedure with actual S&P 500 option-implied volatilities and high-frequency five-minute-based realized volatilities results in significant temporal dependencies in the estimated stochastic volatility risk premium, which we in turn relate to a set of underlying macro-finance state variables. We also find that the extracted volatility risk premium helps predict future stock market returns"--Abstract.

Download or read book Identifying Volatility Risk Premia from Fixed Income Asian Options written by Caio Almeida and published by . This book was released on 2018 with total page 43 pages. Available in PDF, EPUB and Kindle. Book excerpt: Fixed income Asian options are frequently adopted by companies to hedge interest rate risk. Having a payoff structure depending on the cumulative short-term rate makes them particularly informativeabout interest rate volatility risk. Based on a joint dataset of bonds and Asian interest rate options, we study the inter-relations between bond and volatility risk premiums in a major emerging fixed income market. We propose and implement a dynamic term structure model that generates an incomplete market, compatible with a preliminary empirical analysis of the dataset. Approximation formulas for at-the-money Asian option prices avoid the use of computationally intensive Fourier transform methods, allowing for an efficient implementation of the model. The model generates bond risk premium strongly correlated (89%) with a widely accepted emerging market benchmark index (EMBI-Global), and a negative volatility risk premium, consistent with the use of Asian options as insurance in this market. Volatility premium explains a significant portion (33%) of bond premium, indicating that the Asian options market considerably affects the prices of risk of its neighbor bond market.

Download or read book Volatility Arbitrage as a Hedge Fund Strategy written by Michael Huber and published by . This book was released on 2007 with total page pages. Available in PDF, EPUB and Kindle. Book excerpt: I empirically investigate whether variance risk is priced in options on the Swiss Market Index (SMI) and individual stock options on SMI constituent stocks. Based on a model-free implied variance estimator derived by Britten-Jones and Neuberger (2000), I obtain variance risk premium estimates for the SMI and all individual stocks included in the index. I find evidence for a negative variance risk premium priced in SMI options. I do not find that variance risk is priced in individual stock options. I then decompose total index variance into individual variance risk and correlation risk. Based on this decomposition, I find evidence for a large and negative correlation risk premium. I do not find that variance risk other than correlation risk is priced in option prices. Priced correlation therefore potentially offers a risk-based explanation for the differential pricing of index options versus individual stock options.

Download or read book Volatility as an Asset Class written by Samuel Reber and published by . This book was released on 2007 with total page pages. Available in PDF, EPUB and Kindle. Book excerpt: This thesis examines the characteristics of volatility as an asset class through an analysis of the return characteristics of eight simple volatility trading strategies that involve trading in futures and options on the CBOE volatility index VIX and in S&P 500 Index straddles. Particular attention is paid to the profitability and the potential diversification and hedging benefits arising from adding volatility to an S&P 500 portfolio. While the characteristics of the VIX imply substantial diversification benefits from combining volatility with an S&P 500 portfolio, the overall results for seven out of the eight trading strategies are very disappointing. Except for one VIX futures trading strategy, each trading rule generated large losses. This finding corresponds to the broad empirical evidence for a negative volatility risk premium. More-over, the results indicate that in a persistently low volatility environment, holding near-term VIX futures is very expensive. Trading in long-term futures contracts is much cheaper and therefore, this strategy could provide an interesting instrument to diversify an S&P 500 portfolio. Overall, the findings imply that VIX derivatives cannot replicate the characteristics of the underlying volatility index. The returns of the straddle trading strategies show that the negative time decay effect is particularly important. Hence, straddles should not be created with short-lived options. Furthermore, the results indicate that each volatility trading strategy provides insurance against equity market crashes. Yet, the highly negative volatility risk premium prevents costs effective hedging of S&P 500 portfolios by adding volatility.