Can Tests Based on Option Hedging Errors Correctly Identify Volatility Risk Premia?
Branger Nicole, Schlag Christian
Abstract
Tests for the existence and the sign of the volatility risk premium are often based on expectedoption hedging errors. When the hedge is performed under the ideal conditions ofcontinuous trading and correct model specification, the sign of the premium is the sameas the sign of the mean hedging error for a large class of models. We show that discretetrading 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 showthat delta-gamma hedges do not increase the reliability of the test.
Publication type
Research article (journal)
Peer reviewed
Yes
Publication status
Published
Year
2008
Journal
Journal of Financial and Quantitative Analysis
Volume
43
Issue
4
Start page
1055
End page
1090
Language
English
ISSN
0022-1090
DOI
Full text