The Pricing of Tail Risk and the Equity Premium: Evidence from International Option Markets

Research output: Working paper

Abstract

The paper explores the global pricing of tail and equity-index risk as manifest in equity-index options. We document the presence of a left tail factor that displays large persistent shifts, largely unrelated to the corresponding dynamics of return volatility. This left tail factor is a potent predictor of future excess equity-index returns, while the implied volatility only forecasts future equity return variation, not the expected returns. We conclude that the option surface dynamics embed separate equity risk and risk premium factors which are successfully disentangled by our simple two-factor affine model for all the equity indices explored. The systematic deviations across countries speak to the differential risk and its pricing during the great recession and the European sovereign debt crises. Most strikingly, the Southern European indices are subject to much higher tail risk pricing following the onset of the sovereign debt crisis. Nonetheless, intriguing differences emerge between Italy and Spain, likely reflecting time-variation in the perceived exposure towards the risk that either country may be forced to withdraw from the euro currency area.
Original languageEnglish (US)
Number of pages47
StatePublished - 2016

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