Expected Option Returns and Changes of Underlying Volatility

Derivative contracts, especially options, received their popularity in the early 80s and during the last two years trading activities in option market worldwide reached around $ 22 billion contracts. The vast amount of theoretical and scientific research, starting with pioneering works by Black/Sholes 1973 and Merton 1973, is dedicated to the analysis of option price dynamics. One stream of the literature is focused on theoretical foundations to price options, where another stream is directed at the empirical evidence on how the risk (volatility) of the underlying influences option prices. Less extensive scientific research is done to investigate the dynamics of option returns. The aim of this research project is to empirically analyse the sensitivity of option returns towards changes in underlying volatility as well as its magnitude. This paper contributes to the existing literature in two dimensions. Firstly, the aggregate risk measure is decomposed into two components, i.e. systematic and idiosyncratic volatility, with the robust test applying EGARCH model to estimate the volatility. Secondly, this is the first analysis that takes into consideration not only the US market but also the EU market option data.