AAA Spark Meeting of the Regions

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Fair Value Assets and Variance Risk Premiums for Financial Stocks

Fri, June 2, 2:00 to 3:00pm, Virtual, TBA

Abstract

Financial firms hold large amounts of fair value assets. However, some balance sheet values are based on quoted prices while others use model-based prices and manager inputs (“opaque assets”; i.e., Level 2 and Level 3 assets). I test if financial firms’ holdings of opaque assets are associated with variance risk premiums in equity options. I find strong evidence that firms with large holdings of Level 3 assets have lower variance risk premiums and more negative straddle returns. These results hold conditional on several other factors including industry membership, option-implied risks, and a proxy of option mispricing, and option market liquidity. I also present evidence that implied volatilities are less predictive of future volatilities for financial firms with large opaque fair value asset holdings. Finally, I show that opaque fair value assets are associated with variance risk premiums for small and large financial firms.

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