James S. Doran

Implications for Asset Returns in the Implied Volatility Skew

This study examined the impact on future asset returns of information contained in the implied volatility skew. Future returns are linked to the discrepancy between call and put volatilities of at-the-money options and to the left side of the volatility skew, calculated as the difference between out-of-the-money and at-the-money puts. The findings discourage the use of skew-based measures for forecasting equity returns without fully parsing the skew into its most basic portions. We examine the impact on future asset returns of information contained in the implied volatility skew. Future returns are linked to the discrepancy between call and put volatilities of at-the-money options and to the left side of the volatility skew, calculated as the difference between out-of-the-money and at-the-money puts. The predictability of the volatility skew is found in U.S. and international markets, as well as in equities and ETFs. Our findings discourage the use of skew-based measures for forecasting equity returns without fully parsing the skew into its most basic portions.

Short-Sale Constraints and the Idiosyncratic Volatility Puzzle: An Event Study Approach

Using three natural experiments, we test the hypothesis that investor overconfidence produces overpricing of high idiosyncratic volatility stocks in the presence of binding short-sale constraints. We study three events: IPO lockup expirations, option introductions, and the 2008 short-sale ban on financial firms. Consistent with our prediction, we show that when short-sale constraints are relaxed, event stocks with high idiosyncratic volatility tend to experience greater price reductions, as well as larger increases in trading volume and short interest, than those with low idiosyncratic volatility. These results hold when we benchmark event stocks with non-event stocks with comparable idiosyncratic volatility. Overall, our findings suggest that biased investor beliefs and binding short-sale constraints contribute to idiosyncratic volatility overpricing.

The Influence of Tracking Error on Volatility Premium Estimation

I investigate whether the volatility risk premium is negative in energy and equity markets by examining the statistical properties of delta-gamma hedged option portfolios (selling the option, hedging with the underlying contract, and correcting for tracking error with an additional option). By correcting for gamma, these hedged portfolios are not subject to the same discretization and model misspecification problems as traditional delta-hedged portfolios. Within a stochastic volatility framework, I demonstrate that ignoring an options gamma can lead to incorrect inference on the magnitude of the volatility risk premium. Using a sample of S&P 100 Index and natural gas contracts, empirical tests reveal that the delta-gamma hedged strategy outperforms zero and the degree of over-performance is proportional to the level of volatility.

Option Market Efficiency and Analyst Recommendations

This paper examines the information content in option markets surrounding analyst recommendation changes. The sample includes 6,119 recommendation changes for optionable stocks over the period January 1996 through December 2005. As expected, mean underlying asset returns are positive (negative) on days of recommendation upgrades (downgrades). However, volatility levels and shifts prior to recommendation changes explain a significant portion of underlying asset price responses. Ex-ante price and volatility responses in option markets are linked to increased jump uncertainty risk premia. Our findings suggest information in option markets leads analyst recommendation changes, implying revisions contain less information than previously thought. Copyright (c) 2010 Blackwell Publishing Ltd.

Firm Specific Option Risk and Implications for Asset Pricing

This paper examines the benefits and costs of investing in firm specific options as an additional investment in a portfolio. We examine twelve option strategies and find that there is significant negative (positive) abnormal return to buying (selling) puts from January 1996 through July 2006. There is almost no additional benefit from going long any option, and some benefit from selling calls, dependent on the amount option leverage taken. Additionally, we find that the premiums from selling puts are not related to any specific firm characteristic, suggesting a pervasive premium for puts. Asset pricing tests that include market option return factors are unable to explain the returns to firm specific options. Tests on delta-hedged portfolios confirm that the gains to puts are related to idiosyncratic volatility and not market volatility. This is indicative an idiosyncratic volatility risk premium that is distinct from idiosyncratic price risk.

On the Demand for Portfolio Insurance

While insurers manage underwriting risk with various methods including reinsurance, insurers increasingly manage asset risk with options, futures, and other derivatives. Previous research shows that buyers of portfolio insurance pay considerably for downside protection. We add to this literature by providing the first evidence on the cost of portfolio insurance, the payoff to portfolio insurance, and the relative demand for portfolio insurance across VIX levels. We find that the demand for portfolio insurance is relatively high at low levels of VIX, suggesting purchasers demand more downside protection when this protection is cheap on an absolute basis (but expensive on a relative basis). We also provide the first evidence on the hedging behavior of specific investor classes, and show that the demand for portfolio insurance is driven by retail investors (individuals) who buy costly insurance from institutional investors. Results are consistent with other types of paradoxical insurance-buying behavior.

Call-Put Implied Volatility Spreads and Option Returns

Prior literature shows that implied volatility spreads between call and put options are positively related to future underlying stock returns. In this paper, however, we demonstrate that the volatility spreads are negatively related to future out-of-the-money call option returns. Using unique data on option volumes, we reconcile the two pieces of evidence by showing that option demand by sophisticated, firm investors drives the positive stock return predictability based on volatility spreads, while demand by less sophisticated, customer investors drives the negative call option return predictability. Overall, our evidence suggests that volatility spreads contain information about both firm fundamentals and option mispricing.

Is There Money to Be Made Investing in Options? A Historical Perspective

This paper examines the historical performance of 12 portfolios that include S&P 100/500 index options. Each option portfolio is formed using options with different maturities and moneyness, while incorporating bid-ask spreads, transaction costs, and margin requirements. Raw and risk-adjusted returns of option portfolios are compared to a benchmark portfolio that is only long the underlying asset. This allows the marginal impact of including options in the portfolio to be examined. The analysis reveals that including options in the portfolio most often results in underperformance relative to the benchmark portfolio. However, a portfolio that incorporates written options can outperform the benchmark on a raw and risk-adjusted basis. This result is dependent on restricting option investment relative to the maximum allowable margin. While positive and significant risk-adjusted performance is observed for some option portfolios, greater risk tolerance relative to the long index benchmark portfolio is required.

Market Crash Risk and Implied Volatility Skewness: Evidence and Implications for Insurer Investments

Insurers in the U.S. hold over

Estimation of the Risk Premiums in Energy Markets

5 trillion in assets, with approximately