Essays in Empirical Asset Pricing

Vadim di Pietro

doi:https://doi.org/10.21985/N2PM7K

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Essays in Empirical Asset Pricing

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The first chapter of this dissertation investigates 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. The second chapter investigates the relative importance of implied volatilities, high frequency data, intradaily jumps, and earnings announcements for forecasting monthly volatilities on 30 Dow Jones stocks between 1996 and 2004. High frequency based forecasts substantially outperform daily data-based forecasts, but no benefit is derived from decomposing volatility into diffusive and intradaily jump components. Black-Scholes and model-free measures of implied volatility prove more informative than historical-based forecasts. The model-free measure is slightly more informative than the Black-Scholes measure. Surprisingly, volatility forecasting is improved by controlling for an earnings announcement in the previous month. In certain specifications, the lagged earnings announcement indicator remains significant after controlling for option-implied volatilities. The third chapter links uninformed demand shocks with the profits and risks of pairs trading. Usually employed by sophisticated investors, pairs trading is a relative value strategy that simultaneously buys one stock while selling another. In a market with limited risk bearing capacity, uninformed demand shocks cause temporary price pressure. A pair of stock prices that have historically moved together diverge when subjected to differential shocks. Uninformed buying is shown to be the dominant factor behind the divergence. A strategy that sells the higher priced stock and buys the lower priced stock earns excess returns of 10.18% per annum

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