Moneyness, Underlying Asset Volatility, and the Cross-Section of Option Returns

Kevin Aretz, Ming-Tsung Lin, Ser-Huang Poon

Research output: Contribution to journalArticlepeer-review


We study the effect of an asset’s volatility on the expected returns of European options on the asset. Deriving predictions from a stochastic discount factor model, we show that the effect depends on whether variations in the asset’s volatility are driven by systematic or idiosyncratic volatility. While idiosyncratic-volatility-induced variations only affect the option elasticity, systematic volatility-induced variations also oppositely affect the expected return of the asset. Since the expected asset return (elasticity) effect dominates for options with more linear (non-linear) payoffs, systematic volatility prices sufficiently in-the-money (out-of-the-money) options with the opposite (same) sign as idiosyncratic volatility. Using single-stock calls as test assets, double-sorted portfolios and Fama-MacBeth (1973) regressions broadly support the model’s predictions.
Original languageEnglish
Pages (from-to)289-323
Number of pages35
JournalReview of Finance
Issue number1
Publication statusPublished - 18 Jan 2022


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