Abstract: We find consistent evidence across ratings and regions that delta-hedged credit index options have large negative Sharpe ratios and much more so than their equity index counterparts. Risk-factors extracted from equity index options have only moderate explanatory power for the time-series and cross-sectional variation in credit option returns, while a single credit-specific factor explains much of the remaining variation. We link this factor to credit option order flow in a manner that is consistent with the predictions of a demand-based option pricing model, in which order-flow risk is priced in equilibrium.
Mahyar Kargar, University of Illinois-Urbana-Champaign
Jiacui Li, University of Utah
Abstract: Classical asset pricing models predict that optimizing investors exhibit extremely high demand elasticities, while empirical estimates are significantly lower—by three orders of magnitude. To reconcile this disparity, we introduce a novel decomposition of investor demand elasticity into two key components: “price pass-through,” which captures how price movements forecast returns, and “unspanned returns,” reflecting a stock’s lack of perfect substitutes. In a factor model framework, we show that unspanned returns become significant when models include “weak factors.” Classical models overestimate demand elasticity by assuming both very low unspanned returns and high price pass-throughs, assumptions that are inconsistent with empirical evidence.
Discussant: Paul Huebner, Stockholm School of Economics
Abstract: This paper proposes a theoretical framework for recovering investors' subjective beliefs using holdings data and option prices under the assumption of no-arbitrage. We empirically document that the statistical properties of subjective expected returns and Sharpe ratios differ wildly across investor type and depend crucially on their portfolio composition. While expected returns estimated from price data alone suggest that expected returns are highly volatile and countercyclical, including holdings data can imply returns that are less volatile and procyclical. Using buy and sell orders on S&P500 options, we show that the expected returns inferred from retail and institutional investor beliefs increase in bad times when they become the net suppliers of crash insurance in option markets, mirroring price-based estimates. Market makers' expected returns decrease during bad times when they become the net buyers of crash protection when their constraints bind. Finally, we show that market makers' expected returns are highly correlated with survey measures of expected returns by sophisticated agents, while customers' expected returns are not.
