Options and The Volatility Risk Premium

Classical mean-variance portfolio theory assumes that investors are risk-averse. Here's a paper that examines the "volatility risk" premium using options data, titled "The Price of Market Voilatility Risk", by Jefferson Duarte and Christopher Jones:

We analyze the volatility risk premium by applying a modified two-pass Fama-MacBeth procedure to the returns of a large cross section of the returns of options on individual equities. Our results provide strong evidence of a volatility risk premium that is increasing in the level of overall market volatility. This risk premium provides compensation for risk stemming both from the characteristics of the option contract and the riskiness of the underlying equity. We also show with a large scale Monte Carlo simulation that measurement error in option prices and violations of arbitrage bounds induce highly economically significant biases in the mean returns of options. In fact, our simulation results demonstrate that biases can be up to several percentage points per day. These large biases can lead researchers to faulty conclusions with respect to both the magnitude of the volatility risk premium and the sign of expected option returns.

Read the whole thing here.

While their paper does a good job of showing how option returns in academic studies can be biased by bid-ask spread, they also give some nice results on just how big the "volatility premium" may be (they're not the first to find this, but I like their results nonetheless).

The following table from the paper, shows mean returns on S&P 500 index options at various maturities (Short, Medium, Long) and degrees of of moneyness (In The Money, At The Money, Out of The Money). The figures are in basis points/day and are adjusted for bid-ask spread biases. What I found most striking were the results for short positions on short-term deep out-of-the-money puts (4% return per day) and deep OTM calls (3-9% per day).

Now THAT's definitely a table suitable for use in class.

HT: CXO Advisory Group

Informed traders and Optons Markets

If you were an informed trader, would you trade in the options market or in the market for the underlying asset? Finance theory says you'd trade in the options market because of increased leverage.

Now here's another paper that supports this idea. In their March 2008 paper Xiaoyan Zhang, Rui Zhao and Yuhang Xing look at whether relatively expensive put options can be used as "bad news" indicators. Here's the abstract of their paper:

The shape of the volatility smirks has significant cross-sectional predictive power for future equity returns. Stocks exhibiting the steepest smirks in their traded options underperform stocks with the least pronounced volatility smirks in their options by around 15% per year on a risk-adjusted basis. This predictability persists for at least six months, and firms with steepest volatility smirks are those experiencing the worst earnings shocks in the following quarter. The results are consistent with the notion that informed traders with negative news prefer to buy out-of-the-money put options, and that the equity market is slow in incorporating the information embedded in volatility smirks.

Read the whole thing here.

In case you're not familiar with the term, the volatility "smile" refers to the phenomenon that implied volatility increases for options that are further out of the money. If the increase in implied volatility is greater on one side than on the other, the pattern is known as a volatility "smirk". In the case of this paper the smirk is used as an indicator of the degree to which puts or calls are relatively expensive. For example, if calls are relatively more expensive, that is taken as an indicator that informed traders have been buying calls because they have positive information about a stock, with expensive puts being an indicator that traders possess bad news.

In addition to predicting subsequent returns, the authors also find that firms with the most expensive put options are more likely to have the worst negative earnings shocks in the following quarter.

All in all, a pretty cool paper that indicates how information from one market can predict movements in another.

HT: CXO Advisory Group

An Ethical Weekend

Spent the weekend going through the Ethics material for the CFA Level 2 exam. It's pretty dry, and nary a number in over 200 pages of text. But, the Level 2 exam is weighted about 10% on the exam, so it's got to be done.

Now all I have is a quick review of Portfolio Management (I've gone through it once already, but after 299 pages of Ethics, I needed to see some numbers) and then it's on to Derivatives (for the first time). So, with luck, I should be done with my first pass through the Level 2 material with over 5 weeks to go.

The next topic after Derivatives will be a review of Financial Statement Analysis. Although I've put some time in, it's still my weakest topic, and it could comprise a quarter of the exam.

Is Valuation Driven More By Cash Flows or Discount Rates?

Here's one for my next semester's Security Analysis class: In "What Drives Stock Price Movement?" Long Chen and Xinlei Zhao use analyst forecast and stock market data to examine whether stock price changes are associated more with changes in cash flows or discount rates. Here's the abstract (note: the emphasis is mine):

A central issue in asset pricing is whether stock prices move due to the revisions of expected future cash flows or/and of expected discount rates, and by how much of each. Using consensus cash flow forecasts, we show that there is a significant component of cash flow news in stock returns, whose importance increases with investment horizons. For horizons over three years, the importance of cash flow news far exceeds that of discount rate news. These conclusions hold at both firm and aggregate levels, and diversification only plays a secondary role in affecting the relative importance of cash flow/discount rate news. The conventional wisdom that cash flow news dominates at the firm level but discount rate news dominates at the aggregate level is largely a myth driven by the estimation methods. Finally, stock returns and cash flow news are positively correlated at both firm and aggregate levels.

HT: CXO Advisory Group

The Semester Winds Down

It's that time of the year - I have one more day of classes, followed by final exams. My student-managed investment fund did a bang-up job on their end-of-semester presentation to the advisory board, so that's another big item to cross off the list.

So now all I have to do is write a couple of final exams, grade them and some final projects, and start my summer.

The only downside to the end of the spring semester is that there are always a couple of students who thought they were "graduating seniors" who found out only the second part of the phrase is correct. But for the most part, they already know where they stand.

Now it's on to summer research and studying for the CFA level 2 exam (only 42 days until the big one).

Empirical Finance Research

When Financial Rounds first started out, a number of the bigger names in the finance/econ blogoshpere were nice enough to mention this site. So, whenever possible I try to pay the favor "forward" by doing the same for newer blogs. The latest new finance blog of note is titled Empirical Finance Research, which is intended to (in the authors' own words):

1. Highlight research from the academic finance archives that may be useful to investors.
2. Serve as a venue for the contributors to share our thoughts and insights with others who enjoy empirical finance research.
3. Act as an outlet for authors or readers who would like to showcase their latest research.

It's authored by three guys (two of which are currently pursuing Ph.D.s in finance), and focuses on investment applications of current academic finance research. Good job, gentlemen, and keep up the posting. After all, the world needs more blogs run by finance PhDs.

Part-Time Ph.D. Programs

I've had a number of emails asking if it's possible to go to a reputable finance Ph.D. program on a part time basis. Unfortunately, the writers probably won't like the answer. To the best of my knowledge, it's not possible -- and a program that offers a part time doctoral program probably isn't worth it.

Getting a doctorate in Finance isn't like getting a "Super MBA" - it's a totally different animal. First off, the level of material is both more difficult and much less structured. Second, it's geared towards producing future scholars. So, a big part of the doctoral process involves "acculturation" to the academic world. The (very) strange world of the finance academic scholar is generally best learned by a) seeing how academics arrange their day-to-day lives, and b) being able to ask frequent questions of faculty or peers on an irregular basis. These are best done by living with the natives. After all, An anthropologist usually ends up living with the people he's studying (at least for a while), and a doctoral student should too.

Finally, writing a dissertation is extremely difficult when working full time. At the front end of the process (determining the research question and working toward a proposal), it's important to have access to faculty (I shudder to think how many times I imposed on one committee member or another with "just one LITTLE question").

Then, when you're in the writing phase, you need regular blocks of uninterrupted time. It's hard writing while working. This is why so many students who take a visiting teaching position while writing their dissertation take so much longer to finish (if they finish at all).

I realize that taking a few (i.e. 4-5) years off to get a Ph.D. is a huge committment. In a perfect world, you could do it part time so people wouldn't have to pay such a price (3-4 years of lost income and a lot of studying). Unfortunately, doing it that way probably wouldn't do the job in the same way that the current system does.

As a result, a program that offers a "part time" doctoral program wouldn't be well respected, and it's graduates would have an impossible time getting jobs in academia. I could be mistaken, but it's true as far as I know.

A Crazy Week

The semester is winding down - only two weeks of classes to go. Still, they'll be crazy ones. I just got back from a conference, which took several days out of my schedule. The next few days I'll be feverishly trying to finish up a paper for submission in time for a colleague to put it on her 3-year mid-tenure review (if we get it submitted by Friday he can count it, but not if we submit it later. And since he hasn't done as much writing in the last three years as he should have, this piece is important to him.

In addition, my student-managed investment fund class has to prepare our end-of-semester report for our advisory board, and I still have to create a couple of problem sets and final exams in the next week.

I know I say this every year at this time, but man, am I tired. But at least it's only two more weeks and then finals (followed by alcohol, and then sleep).

Ah well, it still beats a job in industry by a country mile.

Perverse Incentives In Academia

I came across this Dilbert cartoon the other day, and it reminds me of academia.

I've had (tenured) colleagues who regularly "blow up" at one thing or another. It could be that they don't like their teaching schedule (or the number of courses they teach). It could be about travel funds. Regardless, what often happens is that the dean (or deparetment chair) tries to sooth the affronted party by giving them a better schedule, more travel funds, etc...

To summarize, the pattern is

1. Teaching schedule is floated aound
   
2. Colleague gripes about teaching load
3. Dean gives colleague reduced teaching load or better schedule
   

Does anyone see a problem here? Maybe it's me, but it looks like someone's being trained to complain. This is a classic case of perverse incentives.

Unfortunately, I'm not yet tenured, so complaining on my part will only result in my being on the job market once again. So I guess perverse incentives of the Bitch and Get Rewarded variety are only for tenured faculty.

But you already knew that.

Five Good Commercials

Here are some pretty funny commercials from Ameriquest Mortgage (combined into one video)


HT: Some other blogger who I forgot to write down.

Get The Wall Street Journal Online For Free

Either on the blog or in class, I refer to articles in the Wall Street Journal a lot. Unfortunately, the person I'm talking to often doesn't have a subscription. Fear no more - it turns out there's a way to get all the content on the WSJ Online for free. Here's how it works: If you click on a link to the WSJ's "protected" content through a non"portal" site, you get sent to a limited version of the full article. To get the whole thing, you have to log in.

But if you click on a link to that same article in Google News or Digg, you can access the full story for free. Here's how to use this approach:

• Many (not all, but many) of the articles are available through Google News. If you know the title of the article, go there and search for it. If it's available, you'll get the full article. Unfortunately, not all articles are available through this avenue.
• If you're a FireFox user, there's another way. First, install the add-on refspoof. Then, when going to the WSJ online, use www.digg.com as the spoofed address. This makes it look to the WSJ site like you're coming from Digg. I've downloaded it, and it's easy to use.
  
• If you're an Internet Explorer user, QuickSpoof and Spooph provide the same spoofing functionality.

HT: The Aleph Blog.

Traders Gone WIld

I was talking to a trader friend of mine the other day and he pointed me to this cartoon.

With the recent volatility in the markets, that pretty much sums it up.

HT: The Big Picture

Click on the link - the comments below the post are pretty funny.

updated 4/3: A reader asked who the cartoonist is, so I googled him. It's Mike Keef of the Denver Post. You can see his other work here.