The Relative Pricing of Index and Equity Options

This thesis is made up of three essays that explore the informational content of index and individual equity option prices.;In the first essay, we investigate the pricing of systematic variance risk in the equity options market. Cross sectional tests on synthetic variance swap returns reveal no evidence of a negative market variance risk premium. Furthermore, we show that a class of linear factor models cannot simultaneously explain index and equity option prices. In particular, equity options appear to be underpriced relative to index options. To exploit the mispricing, we analyze an investment strategy known as dispersion trading. After transaction costs, the strategy generates a Sharpe ratio which is more than four times greater than that of the market. We also find that equity option prices are related to underlying firm characteristics: Options on small and value stocks are more expensive than options on large and growth stocks, respectively. In the second essay we investigate the computation of one of the most important tools in finance practice, market betas. Existing approaches compute market betas using historical data. While these approaches differ in terms of statistical sophistication and the modeling of the time-variation in the betas, they are all backward-looking. This essay introduces a radically different approach to estimating market betas. We use information embedded in the prices of individual equity and index options to compute an option-implied market beta at the daily frequency. This beta can be computed using option data for a single day, and is able to reflect sudden changes in the structure of the underlying company. Based on an empirical investigation of daily cross-sections of option contracts on one hundred underlying companies, we conclude that these option-implied betas contain information relevant for forecasting future betas that is not contained in historical betas. In the third essay, we propose the use of option-implied beta, along with option-implied volatility and skewness, to assess changes in risk of acquiring firms around acquisitions. The option-implied beta is also used to decompose option implied volatility into systematic and idiosyncratic components. Through an event study, we find that acquiring firms are on average riskier after acquisitions, with the added risk reflected in higher option-implied betas, total and systematic volatilities and exhibit higher negative skewness. We show that the same conclusion cannot be reached using the traditional estimates of market beta that use historical stock returns because of their backward-looking nature and their sensitivity to temporary abnormal stock price movements around acquisitions.