RFS Advance Access originally published online on May 4, 2009
Review of Financial Studies 2009 22(11):4493-4529; doi:10.1093/rfs/hhp032
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Understanding Index Option Returns
Columbia University
London Business School and CEPR
Columbia University
Send correspondence to Mikhail Chernov, London Business School, Regent's Park, London NW1 4SA, United Kingdom. E-mail: mchernov{at}london.edu.
JEL Classification: C12, G13
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Abstract |
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Previous research concludes that options are mispriced based on the high average returns, CAPM alphas, and Sharpe ratios of various put selling strategies. One criticism of these conclusions is that these benchmarks are ill suited to handle the extreme statistical nature of option returns generated by nonlinear payoffs. We propose an alternative way to evaluate the statistical significance of option returns by comparing historical statistics to those generated by option pricing models. The most puzzling finding in the existing literature, the large returns to writing out-of-the-money puts, is not inconsistent (i.e., is statistically insignificant) relative to the Black-Scholes model or the Heston stochastic volatility model due to the extreme sampling uncertainty associated with put returns. This sampling problem can largely be alleviated by analyzing market-neutral portfolios such as straddles or delta-hedged returns. The returns on these portfolios can be explained by jump risk premiums and estimation risk.
We thank David Bates, Alessandro Beber, Oleg Bondarenko, Peter Bossaerts, Pierre Collin-Dufresne, Kent Daniel, Joost Driessen, Bernard Dumas, Silverio Foresi, Vito Gala, Toby Moskowitz, Lasse Pedersen, Mirela Predescu, Todd Pulvino, Alex Reyfman, Alessandro Sbuelz, and Christian Schlag for helpful comments. This paper was presented at the Adam Smith Asset Pricing conference, the 2008 AFA meetings in New Orleans, the Amsterdam Business School, AQR Capital Management, College of Queen Mary, Columbia, the ESSFM meetings in Gerzensee, the Fields Institute in Toronto, Goldman Sachs Asset Management, HEC-Lausanne, HEC-Montreal, Lugano, Manchester Business School, Minnesota, the NBER Summer Institute, Tilburg, Universidade Nova de Lisboa, the 2nd Western Conference in Mathematical Finance, and the Yale School of Management. We thank Sam Cheung, Sudarshan Gururaj, and Pranay Jain for research assistance. We are grateful to the anonymous referee and to the editor, Matthew Spiegel, whose comments resulted in significant improvements in the paper. Broadie acknowledges support by the National Science Foundation, grant no. DMS-0410234. Chernov acknowledges support by the BNP Paribas Hedge Funds Centre. Broadie and Chernov acknowledge support by the JP Morgan Chase Academic Outreach program.