Option-Implied Term Structures

Abstract

This paper proposes a nonparametric sieve regression framework for pricing the term structure of option spanning portfolios. The framework delivers closed-form, nonparametric option pricing and hedging formulas through basis function expansions that grow with the sample size. Novel confidence intervals quantify term structure estimation uncertainty. The framework is applied to estimating the term structure of variance risk premia and finds that a short-run component dominates market excess return predictability. This finding is inconsistent with existing asset pricing models that seek to explain the variance risk premium's predictive content.

Harvesting the volatility smile in a large emerging market: A Dynamic Nelson–Siegel approach

“…The theoretical explanations for the existence of a volatility smile include the leverage effect (Black, 1976), increased risk aversion and hedging demand for put options in times of market stress (Bollen & Whaley, 2004; Franke et al, 1998) and compensation for bearing short‐run variance risk (Vogt, 2016). Over time, the existence of volatility smile has been documented in other equity options markets globally (Dennis & Mayhew, 2002; Foresi & Wu, 2005), including the Indian options market (Jain et al, 2019).…”

Informed options trading on the implied volatility surface: A cross‐sectional approach

“…They argue that the price of risk depends on the horizon, and that the horizon‐dependent risk appetite has a meaningful impact on asset pricing. Investigating the term structures of variance risk premium implied by the VIX index, Vogt () finds that the term structure of the variance risk premium is dominated by compensation for bearing short‐run variance risk. Johnson () finds that the changes in the shape of the VIX term structure contain information about time‐varying variance risk premia rather than expected changes in the VIX, thus rejecting the expectation hypothesis.…”