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49
DeltaHedged Gains and the Negative Market Volatility Risk Premium
 The Review of Financial Studies
, 2001
"... We investigate whether the volatility risk premium is negative by examining the statistical properties of deltahedged option portfolios (buy the option and hedge with stock). Within a stochastic volatility framework, we demonstrate a correspondence between the sign and magnitude of the volatility r ..."
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Cited by 46 (2 self)
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We investigate whether the volatility risk premium is negative by examining the statistical properties of deltahedged option portfolios (buy the option and hedge with stock). Within a stochastic volatility framework, we demonstrate a correspondence between the sign and magnitude of the volatility risk premium and the mean deltahedged portfolio returns. Using a sample of S&P 500 index options, we provide empirical tests that have the following general results. First, the deltahedged strategy underperforms zero. Second, the documented underperformance is less for options away from the money. Third, the underperformance is greater at times of higher volatility.Fourth, the volatility risk premium significantly affects deltahedged gains even after accounting for jumpfears. Our evidence is supportive of a negative market volatility risk premium.
Understanding the Role of Recovery in Default Risk Models: Empirical Comparisons and Implied Recovery Rates
, 2006
"... This article presents a framework for studying the role of recovery on defaultable debt prices for a wide class of processes describing recovery rates and default probability. These debt models have the ability to differentiate the impact of recovery rates and default probability, and can be employe ..."
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Cited by 26 (0 self)
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This article presents a framework for studying the role of recovery on defaultable debt prices for a wide class of processes describing recovery rates and default probability. These debt models have the ability to differentiate the impact of recovery rates and default probability, and can be employed to infer the market expectation of recovery rates implicit in bond prices. Empirical implementation of these models suggests two central findings. First, the recovery concept that specifies recovery as a fraction of the discounted par value has broader empirical support. Second, parametric debt valuation models can provide a useful assessment of recovery rates embedded in bond prices.
Stochastic risk premiums, stochastic skewness in currency options, and stochastic discount factors in international economies
 Journal of Financial Economics
, 2007
"... We develop models of stochastic discount factors in international economies that produce stochastic risk premiums and stochastic skewness in currency options. We estimate the models using timeseries returns and option prices on three currency pairs that form a triangular relation. Estimation shows ..."
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Cited by 19 (1 self)
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We develop models of stochastic discount factors in international economies that produce stochastic risk premiums and stochastic skewness in currency options. We estimate the models using timeseries returns and option prices on three currency pairs that form a triangular relation. Estimation shows that the average risk premium in Japan is larger than that in the US or the UK, the global risk premium is more persistent and volatile than the countryspecific risk premiums, and investors respond differently to different shocks. We also identify highfrequency jumps in each economy, but find that only downside jumps are priced. Finally, our analysis shows that the risk premiums are economically compatible with movements in stock and bond market fundamentals.
The effect of macroeconomic news on beliefs and preferences: evidence from the options market. NBER Working Paper Series
, 2003
"... We examine the effect of regularly scheduled macroeconomic announcements on the beliefs and preferences of participants in the U.S. Treasury market by comparing the optionimplied stateprice density (SPD) of bond prices shortly before and after the announcements. We find that the announcements redu ..."
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Cited by 12 (1 self)
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We examine the effect of regularly scheduled macroeconomic announcements on the beliefs and preferences of participants in the U.S. Treasury market by comparing the optionimplied stateprice density (SPD) of bond prices shortly before and after the announcements. We find that the announcements reduce the uncertainty implicit in the second moment of the SPD regardless of the content of the news. The changes in the higherorder moments, in contrast, depend on whether the news is good or bad for economic prospects. Using a standard model for interest rates to disentangle changes in beliefs and changes in preferences, we demonstrate that our results are consistent with timevarying risk aversion in the spirit of habit formation. We thank Tim Bollerslev, Jun Cai, and Frank Song for providing the announcements data and Nick
Closedform transformations from risk neutral to realworld distributions
 Journal of Banking and Finance
, 2007
"... Riskneutral (RN) and realworld (RW) densities are derived from option prices and risk assumptions, and are compared with densities obtained from historical time series. Two parametric methods that adjust from RN to RW densities are investigated, firstly a CRRA risk aversion transformation and seco ..."
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Cited by 10 (3 self)
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Riskneutral (RN) and realworld (RW) densities are derived from option prices and risk assumptions, and are compared with densities obtained from historical time series. Two parametric methods that adjust from RN to RW densities are investigated, firstly a CRRA risk aversion transformation and secondly a statistical calibration. Both risk transformations are estimated using likelihood techniques, for two flexible but tractable density families. Results for the FTSE100 index show that densities derived from option prices have more explanatory power than historical time series. Furthermore, the pricing kernel between RN & RW densities may be more regular than previously reported and a more reasonable risk aversion function is estimated. 2 Closedform Transformations from Riskneutral to Realworld Distributions 1.
Failure is an Option: Impediments to Short Selling and Options Prices, working paper
, 2003
"... Regulations allow market makers to short sell without borrowing stock, and the transactions of a major options market maker show that in most hardtoborrow situations, it chooses not to borrow and instead fails to deliver stock to its buyers. Some of the value of failing passes through to option pr ..."
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Cited by 8 (1 self)
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Regulations allow market makers to short sell without borrowing stock, and the transactions of a major options market maker show that in most hardtoborrow situations, it chooses not to borrow and instead fails to deliver stock to its buyers. Some of the value of failing passes through to option prices: when failing is cheaper than borrowing, the relation between borrowing costs and option prices is significantly weaker. The remaining value is profit to the market maker, and its ability to profit despite the usual competition between market makers appears to result from a cost advantage of larger market makers at failing.
Disentangling the Contribution of ReturnJumps and VolatilityJumps: Insights from Individual Equity Options
, 2004
"... This article investigates option models in the encompassing class of stochastic volatility, returnjumps, and volatilityjumps. Relying on individual equity options and method of simulated moments estimation, several major results obtained are, first, that the doublejump process is the least miss ..."
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Cited by 3 (0 self)
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This article investigates option models in the encompassing class of stochastic volatility, returnjumps, and volatilityjumps. Relying on individual equity options and method of simulated moments estimation, several major results obtained are, first, that the doublejump process is the least misspecified and the least demanding in fitting the tailsize and tailasymmetry of individual riskneutral return distributions; second, the doublejump model improves pricing performance beyond returnjumps absent volatilityjumps, and beyond volatilityjumps absent returnjumps; third, between returnjumps and volatilityjumps, the former is empirically more relevant than the latter for pricing options; fourth, the inverse link between volatilityjumps and returnjumps is instrumental for explaining the valuation of deep outofmoney puts and option dynamics of firms with high kurtosis; fifth, stochastic volatility is not as important for individual equity options as it is for index options. Incremental insights that emerge from individual equity options bring clarity to divergent findings on the role of returnjumps and volatilityjumps.
Information content of crosssectional option prices: a comparison of alternative currency option pricing models of the Japanese Yen
 Journal of Futures Markets
, 2006
"... This article implements a currency option pricing model for the general case of stochastic volatility, stochastic interest rates, and jumps in an attempt to reconcile levels of riskneutral skewness and kurtosis with observed option prices on the Japanese yen and to analyze the information content o ..."
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Cited by 2 (0 self)
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This article implements a currency option pricing model for the general case of stochastic volatility, stochastic interest rates, and jumps in an attempt to reconcile levels of riskneutral skewness and kurtosis with observed option prices on the Japanese yen and to analyze the information content of the cross section of option prices by investigating the hedging and pricing performance of various currency option pricing models. The study makes use of both a method of moments and a more traditional generalizedleastsquares (GLS) estimation technique, taking advantage of the fact that methods of moments do not specifically require the use of crosssectional option prices, whereas GLS does. Results centered around the Asia economic crisis of 1997 and 1998 indicate that the cross section of option prices surprisingly does not appear to contain superior information as the two estimation techniques yield relatively similar results once idiosyncratic differences between them are acknowledged. Extensions of
Ex Ante Skewness and Expected Stock Returns ∗
, 2007
"... We use a sample of option prices, and the method of Bakshi, Kapadia and Madan (2003), to estimate the ex ante higher moments of the underlying individual securities ’ riskneutral returns distribution. We find that individual securities ’ volatility, skewness and kurtosis are strongly related to sub ..."
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Cited by 2 (0 self)
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We use a sample of option prices, and the method of Bakshi, Kapadia and Madan (2003), to estimate the ex ante higher moments of the underlying individual securities ’ riskneutral returns distribution. We find that individual securities ’ volatility, skewness and kurtosis are strongly related to subsequent returns. Specifically, we find a negative relation between volatility and returns in the crosssection. We also find a significant relation between skewness and returns, with more negatively (positively) skewed returns associated with subsequent higher (lower) returns, while kurtosis is positively related to subsequent returns. To analyze the extent to which these returns relations represent compensation for risk, we use data on index options and the underlying index to estimate the stochastic discount factor over the 19962005 sample period, and allow the stochastic discount factor to include higher moments. We find evidence that, even after controlling for differences in comoments, individual securities ’ skewness matters. However, when we combine information in the riskneutral distribution and the stochastic discount factor to estimate the implied physical distribution of industry returns, we find little evidence that the distribution of technology stocks was positively skewed during the bubble period–in fact, these stocks have the lowest skew, and the highest estimated Sharpe ratio, of all stocks in our sample. All errors are the responsibility of the authors. We thank Robert Battalio, Patrick Dennis, and Stewart Mayhew for providing data and computational code. We thank Andrew Ang, Leonce Bargeron, and Paul Pfleiderer
Priced risk and asymmetric volatility in the crosssection of skewness
, 2007
"... We investigate the sources of skewness in aggregate riskfactors and the crosssection of stock returns. In an ICAPM setting with conditional volatility, we find theoretical time series predictions on the relationships among volatility, returns, and skewness for priced risk factors. Market returns r ..."
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Cited by 2 (0 self)
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We investigate the sources of skewness in aggregate riskfactors and the crosssection of stock returns. In an ICAPM setting with conditional volatility, we find theoretical time series predictions on the relationships among volatility, returns, and skewness for priced risk factors. Market returns resemble these predictions; however, size, booktomarket, and momentum factor returns show alternative behavior, leading us to conclude these factors are not priced risks. We link aggregate risk and skewness to individual stocks and find empirically that the risk aversion effect manifests in individual stock skewness. Additionally, we find several firm characteristics that explain stock skewness. Smaller firms, value firms, highly levered firms, and firms with poor credit ratings have more positive skewness.