N°24-53: Pricing of Risk in Credit and Equity Index Options—A Role for Option Order Flow?

We find consistent evidence across ratings and regions that delta-hedged credit index options have large negative Sharpe ratios and much more so than their equity index counterparts. Risk-factors extracted from equity index options have only moderate explanatory power for the time-series and cross-sectional variation in credit option returns, while a single credit-specific factor explains much of the remaining variation. We link this factor to credit option order flow in a manner that is consistent with the predictions of a demand-based option pricing model, where order-flow risk is priced in equilibrium.