Abstract

Equity index risk premia vary more than can be explained by market risks and models. I show that index option intermediaries cause variation in risk premia to manage their option positions. When expected volatility is low, intermediaries hold risky short positions. Increasing risk and liquidity premia compensate intermediaries for the risk exposure and lower subsequent demand. When expected volatility is high, intermediaries transfer risky short positions to investors. Intermediaries induce sell orders by quoting relatively higher sell prices and charging wider effective spreads for buyer-initiated trades. As a result, intermediaries’ positions are often riskless when high volatility realizes. Tighter constraints in the financial sector transmit to option intermediaries and create a reluctance to hold positions. The reluctance drives level and variation in crash risk premia independent of market risks. My results suggest that financial institutions’ risk tolerance integrates option markets with other markets.

Speaker

Thomas Grünthaler (Tilburg University)