Systematic Variance Risk Everywhere in Equity Option Markets

Abstract

We propose systematic variance risk as the primary factor for pricing the cross-section of equity option returns. Using a parsimonious factor model with time-varying risk premiums, we find pervasive negative variance risk premiums in index, stock, and ETF options, consistent with asset pricing theory. The magnitudes of the risk premiums are plausible and similar across markets and the cross-section of options. This highlights the central and unifying role of systematic variance risk in option markets. We emphasize aspects of model specification and empirical implementation which play a critical role in establishing this stylized fact and explain differences with existing studies.