DP6239 Understanding Index Option Returns

Author(s): Mark Broadie, Mikhail Chernov, Michael Johannes
Publication Date: May 2007
Keyword(s): jump risk premia, jump-diffusion models, options returns, put pricing puzzle
JEL(s): C13, G12, G13
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6239

This paper studies the returns from investing in index options. Previous research documents significant average option returns, large CAPM alphas, and high Sharpe ratios, and concludes that put options are mispriced. We propose an alternative approach to evaluate the significance of option returns and obtain different conclusions. Instead of using these statistical metrics, we compare historical option returns to those generated by commonly used option pricing models. We find that the most puzzling finding in the existing literature, the large returns to writing out-of-the-money puts, is not even inconsistent with the Black-Scholes model. Moreover, simple stochastic volatility models with no risk premia generate put returns across all strikes that are not inconsistent with the observed data. At-the-money straddle returns are more challenging to understand, and we find that these returns are not inconsistent with explanations such as jump risk premia, Peso problems, and estimation risk.