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Cross section of option returns and idiosyncratic stock volatility

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  • Cao, Jie
  • Han, Bing

Abstract

This paper presents a robust new finding that delta-hedged equity option return decreases monotonically with an increase in the idiosyncratic volatility of the underlying stock. This result cannot be explained by standard risk factors. It is distinct from existing anomalies in the stock market or volatility-related option mispricing. It is consistent with market imperfections and constrained financial intermediaries. Dealers charge a higher premium for options on high idiosyncratic volatility stocks due to their higher arbitrage costs. Controlling for limits to arbitrage proxies reduces the strength of the negative relation between delta-hedged option return and idiosyncratic volatility by about 40%.

Suggested Citation

  • Cao, Jie & Han, Bing, 2013. "Cross section of option returns and idiosyncratic stock volatility," Journal of Financial Economics, Elsevier, vol. 108(1), pages 231-249.
    • Handle: RePEc:eee:jfinec:v:108:y:2013:i:1:p:231-249
    DOI: 10.1016/j.jfineco.2012.11.010
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    References listed on IDEAS

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    More about this item

    Keywords

    Option return; Idiosyncratic volatility; Market imperfections; Limits to arbitrage;
    All these keywords.

    JEL classification:

    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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