Faculty of Economics and Business Administration Publications Database

Can Tests Based on Option Hedging Errors Correctly Identify Volatility Risk Premia?

Branger, Nicole
Volume: 43
Number: 4
Pages: 1055 - 1090
Month: December
ISSN-Print: 0022-1090
Link External Source: Online Version
Year: 2008
Abstract: Tests for the existence and the sign of the volatility risk premium are often based on expected option hedging errors. When the hedge is performed under the ideal conditions of continuous trading and correct model specification, the sign of the premium is the same as the sign of the mean hedging error for a large class of models. We show that discrete trading and model misspecification may cause the standard test to yield unreliable results. In particular, ignoring jump risk premia can lead to incorrect conclusions. We also show that delta-gamma hedges do not increase the reliability of the test.