Variance risk, financial intermediation, and thecross-section of expected option returns

We explore the pricing of variance risk by decomposing stocks' total variance into systematicand idiosyncratic return variances. While systematic variance risk exhibits a negative priceof risk, common shocks to the variances of idiosyncratic returns carry a large positive riskpremium. This implies investors pay for insurance against increases (declines) in systematic(idiosyncratic) variance, even though both variances comove countercyclically. Commonidiosyncratic variance risk is an important determinant for the cross-section of expectedoption returns. These ndings reconcile several phenomena, including the pricing dierencesbetween index and stock options, the cross-sectional variation in stock option expensiveness,the volatility mispricing puzzle, and the signicant returns earned on various option portfoliostrategies. Our results are consistent with theories of nancial intermediation under capitalconstraints.