Reciprocal Return Risk Premium and Option Returns

ABSTRACT This paper presents a robust new finding that reciprocal return risk premium, defined as the difference between the expected reciprocal of return under physical and risk‐neutral measures, significantly predicts the option returns in the cross‐section. Theoretical and empirical evidence underscore the pivotal role of the ex post volatility risk premium in this relation. We also find that the positive relation between reciprocal return risk premium and option return mainly resides in the component, which is by definition a natural measure for return variation under the risk‐neutral measure.