Information in Option Prices

The project is dedicated to the economic analysis of information contained in option prices. The direction of research in this project is two-fold. First, we want to study whether option prices can serve as a useful tool to identify two of the important basic components of fundamental dynamics in equilibrium models, namely diffusive volatility and jump risk. In many papers, these two types of risk are perfectly tied to each other in the sense that the risk of jumps is linearly and monotonically increasing in the current level of volatility. We identify two very simple observable characteristics of the implied volatility smile which provide reliable information on the link between diffusive volatility and jump risk, namely the level of the smile and its slope. If the standard assumption were valid, these two quantities would have to move in perfect lockstep. In the data, however, they do not. This is the main motivation for our new general equilibrium model, in which volatility is no longer the driver of jump risk, but intensity can move autonomously. This simple extension generates a much better fit of the model to option price data and allows us to gain a much better understanding of the risk dynamics on financial markets. Second, option prices can help to get a deeper understanding of investor preferences. An intensely debated question is whether investors exhibit a preference of the early resolution of uncertainty, i.e., whether they prefer the realization of a certain type of risk to occur earlier rather than later. Building on a very simple intuition, we suggest to use a measure called “Implied Volatility Duration” (IVD) to conditionally categorize stocks into those where uncertainty is resolved early or late. In case the representative investor requires a premium for stocks with late resolution, this would represent evidence supporting a preference for early resolution. We then want to investigate if the return difference between “late” and “early” stocks represents a risk factor in the universe of stocks. Finally, we plan to develop an equilibrium model which can rationalize the premium we find in the data.