Market Jump Risk and the Price Structure of Individual Equity Options

The role of market jump risk premium implicit in individual equity options has not been examined to date. This paper develops a new factor model for equity returns and option pricing that takes into account the market's diffusive and jump risks. We estimate the model on a large cross section of equity returns and options. We find that market jump risk embedded in equity options is about 3.18%. This magnitude is consistent with those found in index options pricing studies which suggests that the price structure of equity and index options can be explained in a unified framework. In addition, we show that the market jump and diffusive risk premia affect equity option prices differently. Firms with a larger return compensation for the market diffusive risk have a higher option-implied volatility level while firms with a larger return compensation for market jump risk have steeper option-implied volatility slope