Dark Matter in (Volatility and) Equity Option Risk Premiums

Abstract

In their paper, “Dark Matter in (Volatility and) Equity Option Risk Premiums,” Bakshi, Crosby, and Gao ask a provocative question: is there dark matter embedded in volatility and equity options? They consider a theoretical approach that allows them to introduce the constructs of risk premiums on jumps crossing the strike and on local time. The treatment of jumps crossing the strike and local time is integral to their theory because their absence would be counterfactual from an empirical standpoint. They label such abstract uncertainties—driven by unspanned risk components—“dark matter” as these uncertainties can be hard to identify, but their presence is implied in options data, and the workings of dark matter can be economically influential. Their empirical exercises are based on weekly equity index options (the “weeklys”) in addition to the farther-dated (index and futures) options up to 88 days maturity.