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Dark Matter in (Volatility and) Equity Option Risk Premiums

Author

Listed:
  • Gurdip Bakshi

    (Fox School of Business, Temple University, Philadelphia, Pennsylvania 19122)

  • John Crosby

    (Strome College of Business, Old Dominion University, Norfolk, Virginia 23529)

  • Xiaohui Gao

    (Fox School of Business, Temple University, Philadelphia, Pennsylvania 19122)

Abstract

Emphasizing the statistics of jumps crossing the strike and local time, we develop a decomposition of equity option risk premiums. Operationalizing this theoretical treatment, we equip the pricing kernel process with unspanned risks, embed (unspanned) jump risks, and allow equity return volatility to contain unspanned risks. Unspanned risks are consistent with negative risk premiums for jumps crossing the strike and local time and imply negative risk premiums for out-of-the-money call options and straddles. The empirical evidence from weekly and farther-dated index options is supportive of our theory of economically relevant unspanned risks and reveals “dark matter” in option risk premiums.

Suggested Citation

  • Gurdip Bakshi & John Crosby & Xiaohui Gao, 2022. "Dark Matter in (Volatility and) Equity Option Risk Premiums," Operations Research, INFORMS, vol. 70(6), pages 3108-3124, November.
    • Handle: RePEc:inm:oropre:v:70:y:2022:i:6:p:3108-3124
    DOI: 10.1287/opre.2022.2360
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