Guanglian Hu and Yuguo Liu
Existing studies relate the puzzling low average returns on out-of-the-money index call and put options to non-standard preferences. We argue the low option returns are primarily due to the pricing of market volatility risk. When volatility risk is priced, expected option returns match the realized average option returns. Moreover, consistent with its theoretical effect on expected option returns, the volatility risk premium is positively related to future index option returns and this relationship is stronger for OTM options and ATM straddles. Lastly, we find the jump risk premium contributes to some portion of OTM put option returns.