Cross-Sectional Variation of Risk-targeting Option Portfolios

In the U.S., several options exchanges list option contracts on thousands of stocks, and the number of option contracts on each underlying stock differs greatly both over time and across different names. The option behavior varies not only across the different underlying names, but also across the different moneyness and maturities of the option contracts, confounding the comparative analysis. Based on a decentralized return attribution analysis, this paper constructs risk-targeting option portfolios on a stock that target a unit level of risk to a particular risk dimension while hedging away exposures to other risk dimensions. The paper estimates the market pricing of each risk source for each underlying stock and examines the cross-sectional variation of both the market pricing estimates and the ex post realized excess returns on each risk-target option portfolio across the large stock universe. The cross-sectional variation of the market pricing estimate strongly predicts the variation of the portfolio's future excess return in accordance with the expectation hypothesis.