City Research Online

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:	Symplectic Administrator

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