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Type Working Paper
Scope Discipline-based scholarship
Title Variance risk, Financial intermediation, and the cross-section of expected option returns
Organization Unit
Authors
  • Norman Schürhoff
  • Alexandre Ziegler
Language
  • English
Institution University of Zurich
Series Name NCCR
Number 712
Number of Pages 69
Date 2011
Abstract Text 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 signifcant returns earned on various option portfolio strategies. Our results are consistent with theories of financial intermediation under capital constraints.
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