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

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