The Pricing of Volatility and Jump Risks in the Cross-Section of Index Option Returns

In the data, out-of-the-money (OTM) S&P 500 call and put options both have puzzling low average returns. Existing studies relate these results to models with non-standard preferences. We argue that the low returns on OTM index options are primarily due to the pricing of market volatility risk. When volatility risk is priced, expected option returns match the average returns of call and put options across all strikes as well as returns of option portfolios. Consistent with the differential impact of the volatility risk premium on expected option returns, we also find that the market volatility risk premium is positively related to future index option returns and this relationship is stronger for OTM options and ATM straddles. Lastly, we find some portion of OTM put option returns are attributable to the jump risk premium