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| Type | Other Publication |
| Scope | Discipline-based scholarship |
| Title | The Pricing of Systematic and Idiosyncratic Variance Risk |
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| How Published | |
| Date | 2010 |
| Abstract Text | We study the pricing of systematic and idiosyncratic variance risk in the options market. We rst develop a methodology that allows to separately identify risk premia on systematic and, respectively, idiosyncratic variances by combining options data on several indices with the cross-section of options on the index constituents. We nd that both systematic and idiosyncratic variance risk are heavily priced. Systematic variance risk exhibits a negative price of risk, whereas idiosyncratic variance risk carries a large positive risk premium|even though systematic and idiosyncratic variances comove positively. This dierential pricing of systematic and idiosyncratic variance risk allows reconciling several phenomena, (1) the relative prices of index and individual options, (2) the sizeable crosssectional variation in risk premia on individual stock variances, (3) the volatility mispricing puzzle documented by Goyal and Saretto (2009), and (4) the substantial returns earned on various option portfolio strategies. We nd little evidence for an ICAPM-based explanation of the observed patterns, but nd support for theories of nancial intermediation under capital constraints that account for priced idiosyncratic variance risk. |
| Official URL | http://www.insead.edu/facultyresearch/areas/finance/activities/documents/CorrRisk_052710.pdf |
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