Firm Leverage and Equity Option Returns

This paper studies the relation between firm leverage and delta-hedged equity option return both theoretically and empirically. In a capital structure model with double-exponential jump diffusion process, the expected return of delta-hedged equity option portfolio is related to firm’s structural characteristics such as leverage, debt covenants and volatility of the firm’s asset. Under general conditions, these determinants are negatively related to the expected return of the option portfolio and the higher order terms of the determinants also play important roles. Empirically, we find that these structural variables can explain a large portion of the cross-sectional variation in the data and even subsume information in other determinants documented in the literature, such as idiosyncratic volatility and liquidity. The results from the double sorting portfolios support the theoretical implications. The empirical evidence also supports the nonlinear relation between the determinants and the delta-hedged equity option returns. These findings are robust across calls, puts and different moneyness levels.