Why Does Volatility Uncertainty Predict Equity Option Returns?
Cao, J. J., Vasquez, A. A., Xiao, X. 
ORCID: 0000-0002-0564-9795 & Zhan, X. E. (2023).
Why Does Volatility Uncertainty Predict Equity Option Returns?.
The Quarterly Journal of Finance, 13(1),
article number 2350005.
doi: 10.1142/s2010139223500052
Abstract
Delta-hedged option returns consistently decrease in volatility of volatility changes (volatility uncertainty), for both implied and realized volatilities. We provide a thorough investigation of the underlying mechanisms including model-risk and gambling-preference channels. Uncertainty of both volatilities amplifies the model risk, leading to a higher option premium charged by dealers. Volatility of volatility-increases, rather than that of volatility-decreases, contributes to the effect of implied volatility uncertainty, supporting the gambling-preference channel. We further strengthen this channel by examining the effects of option end-users net demand and lottery-like features, and by decomposing implied volatility changes into systematic and idiosyncratic components.
| Publication Type: | Article |
|---|---|
| Additional Information: | Electronic version of an article published as The Quarterly Journal of Finance, 13, 1, 2023, 2350005 https://doi.org/10.1142/S2010139223500052 © copyright World Scientific Publishing Company, http://www.worldscientific.com/worldscinet/qjf. |
| Publisher Keywords: | Delta-hedged option returns; volatility uncertainty; volatility-of-volatility; model risk; gambling preference |
| Subjects: | H Social Sciences > HD Industries. Land use. Labor > HD61 Risk Management H Social Sciences > HG Finance |
| Departments: | Bayes Business School > Finance |
| SWORD Depositor: |
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