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A1745
Topic: Contributions on pricing Title: The pricing of idiosyncratic risk in option markets Authors:  Jean-Francois Begin - Simon Fraser University (Canada)
Christian Dorion - HEC Montreal (Canada) [presenting]
Genevieve Gauthier - HEC Montreal (Canada)
Abstract: The recent literature provides conflicting empirical evidence on the sign of the relationship between idiosyncratic risk and equity returns. New light is shed on this relationship by disentangling four risk factors contributing to the equity risk premium. We exploit the richness of stock option data to extract the expected risk premium associated each risk factor, thereby avoiding the exclusive use of noisy realizations of historical returns. To this end, we develop a jump-diffusion model in which a firms systematic and idiosyncratic risk have both a diffusive and a tail component. Our pricing kernel is such that each risk factor can potentially be priced. This model offers quasi-closed form solutions for the price of European options. We estimate the model on 117 firms that are or were part the S$\&$P 500 index, using equity returns and option prices of the market index and of each individual firm. Our analysis highlights two new results. First, we find that idiosyncratic jump risk is priced to a greater extent than systematic risk. Idiosyncratic jump risk accounts for 55$\%$ of the expected equity premium, on average, compared to 45$\%$ for systematic risk (13$\%$ for the diffusive part and 32$\%$ for the tail risk). Second, we show that the diffusive part of idiosyncratic risk is not priced, once other sources of risk are accounted for. These empirical findings thus contribute to the understanding of the complex relation between idiosyncratic risk and equity risk premium.